One of the features of 2016 so far has been the appearance of QE or Quantitative Easing for corporate bonds with the ECB announcing a start in March and the Bank of England announcing a start earlier this month. This was a particular volte-face for the Bank of England which has had both the ability and the authority to purchase Corporate Bonds for some years now but had previously fiddled around in the market as if it was a market maker before abandoning the whole thing. Oh and at least one member of the Riksbank of Sweden is on the case according to Danske Bank Research.
#RiksbankJochnick getting hot: is she suggesting a end to Govvie QE going into CB’s instead?
What is the rationale behind this?
There are two main routes where this could help the economy. These are via a price mechanism and a quantity one. The price mechanism is via lower corporate bond yields making it cheaper for companies to borrow which in theory will make investments cheaper. The quantity mechanism is that they should be able to issue more corporate bonds ( at lower yields) and that this extra borrowing will allow them to expand and help the economy. So in essence more corporate bonds at cheaper yields will in theory give an economic boost.
The next influence is more prosaic. Other central banks have noticed that the US Federal Reserve bought a lot of private-sector debt and still holds US $1.75 trillion of it and feel that they missed out. Perhaps it achieved a type of holy grail. Copying that is a little awkward as for example the ECB is on its third go at buying the Euro area equivalent ( covered bonds) and would be open to the accusation of being years behind even a johnny come lately. So we have corporate bond purchases which are badged as helping the private sector.
The ECB slaps itself on the back
The ECB has reviewed its own program and declared it to be a success on the two economic grounds I pointed out. First yields.
over the identified period from 10 to 24 March, 11 basis points of the total decline of 16 basis points in the spreads of euro area investment-grade corporate bonds was related to the monetary policy measures announced in March, more specifically the launch of the CSPP.
Then issuance volumes.
While issuance was subdued at the beginning of the year amid elevated financial market uncertainty, it rebounded significantly after the CSPP announcement. Preliminary data suggest that issuance in the second quarter of 2016 was well above the average seen in previous years.
As of the end of last week the ECB had purchased some 17.8 billion Euros of corporate bonds which compares to a total program size of 1207 billion Euros.
What economic effects does lower corporate bond yields have?
The first comes as the theory that lower corporate bond yields leads to more investment collides with reality. On the 11th of this month I pointed out that the US Federal Reserve has its doubts.
Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment………Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases.
At this point a few Ivory Towers will be resembling the Dark Tower of Barad-dûr as the Ring of Power goes into Mount Doom. Also if we stay with the issue of lower yields then Euro area taxpayers may be wondering why they are giving subsidies to big businesses in this way?
Yields of the purchased bonds have ranged from around -0.3% to above 3%, with just above 20% of the purchases being made at negative yields above the ECB’s deposit facility rate of -0.4%.
The incentive to make good investments fades if the money to fund it is in effect free or even more so if you are paid to borrow. On this road more debt could lead to a more sclerotic economy with increasing ossification.
What about “phantom securities”?
This is an issue faced by a previous Bank of England program (Special Liquidity Scheme) where is suddenly discovered that some of what it was buying was not what it thought it was. Awkward! Imagine going back to taxpayers and having to explain that you had been made a fool of. I believe that this was the reason the SLS was wound up early. Can history repeat itself? From the Wall Street Journal.
The European Central Bank’s corporate-bond-buying program has stirred so much action in credit markets that some investment banks and companies are creating new debt especially for the central bank to buy.
Apparently there have been two private placements but like when it was giving private briefings to hedge funds the ECB appears not to have a grip on moral hazard.
“Typically there won’t be a prospectus, there won’t be any transparency, there won’t be a press release. It’s all done discreetly,”
What could go wrong?
I wish to be clear that the ECB is unworried by this and has implicitly asked for it to happen so that it can buy more bonds. The catch is that as described in both Goodhart’s Law and the Lucas Critique changing things like this can have bad consequences and destroy the intended economic effect.
There is an example of the Turning Japanese theme here. Back in one of the earlier versions of QE the Bank of Japan decided to offer cheap loans to smaller companies. The money did not reach them but it did reach the subsidiaries of Nissan, Toyota, Sony et al which suddenly sprang up. But these were pure economic and financial transactions divorced from the real economy as those companies were busy making the Bank of Japan look good not looking for investment finance.
In essence this is yet another central banking program which helps larger businesses and in particular ones large enough to issue corporate bonds. Smaller and medium-sized businesses may reasonably feel that they have been left out again. If you think about it there will be an effect to ossify the financial system and the economy as larger companies which do not do well may simply issue corporate bonds and carry on regardless. As the Cranberries put it.
In your head
In your head
Zombie zombie zombie
What’s in your head
In your head.
Zombie, zombie, zombie
Bank of England problems
The FT published some thoughts from HSBC on the 4th of this month which pointed out this problem.
For the 29 per cent of finance that UK companies obtain from the bond market, more is issued in dollars than in euros, and more in euros than in sterling. Should the Bank choose corporate bond QE, it is not obvious that sterling corporate bonds would be the most effective choice.
So as we stand corporate bond issuance in sterling is a relatively minor deal as shown below.
There are £285bn sterling investment-grade bonds compared with £1.3tn denominated in euros and £4tn denominated in dollars, according to Dealogic.
That could of course grow although that ignores the issue of the fact that UK companies are often international and may choose to issue bonds in Dollars and Euros to match their risks and use bank lending for sterling risks. Ooops! Oh and are you thinking what I am thinking? Well it would appear that the ECB is.
Foreign companies with headquarters located outside
the euro area have not thus far increased their bond issuance in euro.
I wonder who they mean? But UK companies borrowing in Euros and being subsidised to do so by the ECB seems on the face of it to be a bigger opportunity than going to the Bank of England. (Update 9pm The comment from Noo2 below points out that this is in fact would be more difficult than I have said). Now the exchange rate is much lower even that seems to favour Euro borrowing. Perhaps the clearest sign of a sustained turn for the UK Pound will be UK corporates issuing Euro corporate bonds. Quite a potential can of worms……
So on the face of it central bankers will be able to point to lower bond yields and more issuance in response to corporate bond QE. However the latter is not going as well as claimed according to the FT.
While the ECB’s own corporate QE initially lured companies to the bond market — €50bn was sold in March, the month after the policy was announced, supply has since waned.
Also if the problem is demand in the economy as opposed to demand for finance then encouraging businesses to follow the “debt is good” mantra is yet another spider’s web for us to be caught in. Yet another boom for the financial economy that fails to reach the real economy.
I have left pension funds to last. They will be hurt by this as yields go lower again and ironically may buy longer-dated bonds if they are issued. So Bank of England QE will have had the effect of switching them from state backed UK Gilts to private-sector corporate bonds. What could go wrong?
Where is the sledgehammer for the real economy? On this road it is Hall and Oates singing to central bankers.
You’re out of touch