A New Buyer Enters the Corporate Bond Market: The ECB

While it was no surprise that the European Central Bank once again eased its monetary policy in an attempt to stimulate its moribund economy, the amount of the easing was greater and the composition different than the market expected.

The ECB cut the main refinancing rate (the short-term rate it charges member banks) by 5 basis points to 0.00%, lowered the marginal lending facility (overnight rate) 5 basis points to 0.25%, and reduced the deposit facility (the amount the ECB pays to member banks on excess funds) by 10 basis points to negative 0.40%. In an attempt to spur lending, the negative deposit rate effectively means that the ECB is charging a fee to banks that leave excess funds on deposit with the central bank. In addition, the ECB announced it would increase the size of its monthly purchase plan by EUR 20 billion to EUR 80 billion (an annualized run rate of approximately EUR 1 trillion) and conduct four targeted longer-term refinancing operations with 4-year maturities. The interest rate on the TLTROs can be as low as the interest rate on the deposit facility, meaning that the banks would pay back the ECB less than borrowed.

The biggest surprise, however, was the announcement that the ECB would begin to purchase investment-grade corporate bonds issued by nonbank corporations as part of its quantitative easing. The immediate near-term impact of this announcement will be to tighten corporate credit spreads in the European market, but this will have international implications as well. Many issuers have bonds outstanding in other currencies besides euros. For example, for those issuers with both euro- and U.S. dollar-denominated bonds outstanding, as the euro bonds' credit spreads tighten, the credit spread on the dollar-denominated bonds will also tighten. Investors with the ability to purchase either denomination will swap euro bonds for dollar bonds if the dollar spreads are meaningfully wider.

Unlike conventional buyers of corporate bonds, the ECB will not be as price sensitive. Its purchases are intended to implement an easy monetary policy as opposed to conventional purchasers looking to maximize return for a given risk. As such, the ECB's purchases will probably distort the normal market discounting function and artificially suppress credit spreads. Not only are fixed-income investors' returns affected by the abnormally low interest rates due to the negative interest rate policy, but now investors' compensation for accepting corporate credit risk will be reduced as well.

The implementation of this policy raises a host of questions that are currently unanswered. For example, does the ECB have the experience and expertise to assess valuation (that is, the spread at which corporate bonds trade)? How will the ECB manage this portfolio? Will it purchase bonds in the same proportion as a corporate bond index, or will it overweight some sectors and underweight other sectors? What maturity of corporate bonds will it buy? Will it hold bonds to maturity? What if it buys bonds that are subsequently downgraded below investment grade? Does it become a forced seller and distort the market even further? If it doesn't sell bonds that are downgraded, what happens if the bonds it purchased default? The ECB will not begin to purchase corporate bonds until toward the end of the second quarter, and we expect answers will be forthcoming over the next few months as the bank releases more detail regarding the expansion of the asset-purchase program. In the meantime, credit spreads in the corporate market will probably trend tighter.

Over the past few weeks, the U.S. corporate bond market has rallied off its lows. Recent economic metrics indicate that the U.S. economy remains on track to expand at a moderate pace, and oil prices have continued their march higher. The average spread of the Morningstar Corporate Bond Index tightened 12 basis points to +178, and in the high-yield market the Bank of America Merrill Lynch High Yield Master II Index tightened 26 basis points to +682. The equity market was not to be left out of this rally, as the S&P 500 rose 1.1%. Oil also continued to move higher, rising a little over $2 a barrel to $38.50. While investors looked to front-run the ECB and snap up corporate bonds, they looked to reduce holdings in U.S. Treasury bonds. The yield on the 5-year and 10-year Treasuries rose 10 basis points to 1.48% and 1.98%, respectively, and the 30-year yield increased 5 basis points to 2.75%.

Even though underlying interest rates rose, the rally in credit spreads was more than enough to generate a 0.52% gain in the Morningstar Corporate Bond Index, which has risen 1.52% year to date. The Bank of America Merrill Lynch High Yield Master II Index rose 1.2% last week and has generated a 2.52% return thus far this year.