18th April 2016

What if the ECB doesn’t deliver

MARKET CLOSE:
FTSE 100
6,344, -21
DAX
10,052 -42
S&P 500
2,081, -2
iTraxx Main
73bp, +1bp
iTraxx X-Over Index
317bp, +7bp
10 Yr Bund
0.13%, -1bp
iBoxx Corp IG
B+148.6bp, unch 
iBoxx Corp HY Index
B+508bp, -1bp
10 Yr US T-Bond
1.75%, -4bp

Draghi can’t fail to – in one sense…

If the ECB doesn’t deliver on its corporate bond purchase programme, spreads will gap wider, performance will be lost and borrowers will face higher funding costs – although that’s barely a hardship. There will be no repenting at leisure. However, it’s almost inconceivable that the ECB won’t deliver in this sense. However, stepping back, the point of QE and other special measures is to boost the “real” economy.

ecb-president-mario-draghi

ECB President Mario Draghi

The idea centres on the ECB creating a funding transmission mechanism whereby it injects liquidity – indirectly – where it is needed most, and that is the SME sector. These are corporates which need €100-250m in funding, but in capital market terms, these tend to be illiquid issues, not usually benchmark-sized and not of interest to enough institutional investors. These corporates also tend to be speculative grade-rated entities. Fix that, Mr Draghi. We need traditional economics to do the heavy lifting. That is: growth, confidence, investment and reform.

That aside, the size of the programme could disappoint. We have previously estimated that the ECB will struggle to lift anything more than €2bn per month of eurozone-domiciled IG non-financial corporate debt. Anything less than €500m in their monthly purchase intentions – yet to be announced – would probably be seen as failure. We think they will aim for €2bn or more. They have already indicated that it will be non-financial debt and eurozone-domiciled borrowers. So their prices will remain well-supported while the real opportunity, in our view, will be with the rest.

Slightly higher spreads, better liquidity (perhaps) and better returns are to be had there. The disappointment might come from ratcheting spreads (this has stalled in the past couple of weeks), which will make breakevens even more difficult and therefore little to get excited about in the corporate bond market. We are probably aware that at these and lower spread levels – where the prospect of more zero-coupon bonds will come with the slimmest of pickings in yield at reoffer – we are locking in future losses. But we live for the moment.

Whether the transmission mechanism will work is another issue altogether, but for our part we do not think they will succeed with it as things stand. The idea of relying on the capital markets to do the job for the ECB and the political elite is too simple – and misses the broader point. Broader long-term structural reform is needed.

Risk recovery becomes more discerning

The earnings season kicked off and the numbers generally beat lowered expectations, leaving sentiment broadly on the up. We closed out last week in fairly mixed fashion. Equities ended the final session a little lower, government bonds regained some favour and prices edged up (yields lower), while oil prices moved a little lower on Doha shindig apprehension and credit was left better bid for choice amid little real activity.

dax

The DAX held 10,000

The DAX managed to hold 10,000, the S&P stayed in the black YTD by some margin and the FTSE was also holding its head above water for 2016. Bund yields ended the week pretty much unchanged after the 10-year threatened record lows earlier on the week. They were 0.049% a year ago and we got to 0.07%. We think they still will hit a low – give it some time and rope! Oil was holding comfortably above $40 per barrel – at $43 for Brent – and we’ll see how we progress here once the Doha gathering concludes.

High beta risk leads the charge tighter

Higher-beta credit outperformed and was the driver for spread markets last week. This was probably helped by better equities, but we think some will be looking for where value is in the corporate bond market. For instance, the IG Market iBoxx corporate bond index closed at B+148.5bp and while this was the lowest closing level for 2016, it represented just 1.5bp of tightening in the week. CoCos and corporate hybrids felt some better support, and their indices closed 14bp and 26bp lower respectively.

In high yield, the index was lower at B+508bp, representing a drop of 22bp in the week – and the lowest level this year. At 4.80%, the index yield is also at a 2016 low. The sterling market wasn’t to be left behind: spread there, on an index basis, also tightened in the week by 1.5bp, although it is still 11bp wider YTD.

Returns for HY have popped higher to 2.6% YTD and now compare favourably with the IG market, where returns reside at 2.7% for the year to date. There’s much talk about the default rate popping higher in the US this year as the shale gas boom comes to an end and the commodity sector feels some heat. In Europe, growth might be poor and the HY market extremely fragmented as a result, but the default rate is anchored at less than 1.5% currently, and if it rises at all it is not expected to go above 2% by most projections by year-end. The plethora of issuance over 2011-2015 has enabled many corporates to fund at very low levels and extend maturities, while weathering the prolonged economic downturn. All the default headlines therefore ought to remain with US credit.

Corporate refinancing risks are low on the back of the depressed rate/yield environment, and risk- taking minimal. There ought to be much more juice in the HY market from a spread perspective in 2016 still. As for the synthetics, they stayed true to form as the corporate markets risk proxies and reflected the weakness in stocks, ending a touch wider with Main at 73bp and X-Over at 317bp.

Never mind the quality, feel the width

Lots on the earnings front, they’ll beat expectations but few will care that profits are declining and the quality is missing. Twenty percent of the S&P index reports this week, so it promises to be fairly choppy for stocks. Unless stocks indices fall several percentage points, we ought to see no weakness in the cash market. Our eyes are focused on primary, the market generally will be looking to that earnings stream and the oil bash at Doha. Reports indicate that there was no agreement on an output freeze and the early indications point to acrimony.

Have a good day.

Suki Mann

A 25-year veteran of the European corporate bond markets and in his role as Credit Strategist, Dr Mann has been ranked number one in the Euromoney Investor Survey eight times in ten years. Previously with Societe Generale and UBS, he now shares views of events in the corporate bond market exclusively here on Credit Market Daily.