The economics of and problems created by corporate bond QE

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.

Jochnick 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.

Problems

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.

Big Business

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……

Comment

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

 

 

 

 

 

 

 

 

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20 thoughts on “The economics of and problems created by corporate bond QE

  1. Three other problems
    1.this financing goes to large companies who in general terms, are trimming the numbers of employees and not to small companies who tend to be creators of jobs as they grow.
    2. Most large company CEO’s and CFO’s I talk to think ‘my god the economy must be worst than I thought if they are trying these nutty policies’ and they makes them less inclined to hire or invest
    and 3 (related to 2 above) they just use the proceeds of the debt issuance to buy back stock and lever up their balance sheets. The combination of this with the exploding pension fund deficits means corporate leverage has rarely been higher just as the profit cycle is rolling over and these things make the system even less sensitive to a shock.

  2. Hi Shaun
    As you so eloquently put it, our friends
    in charge seem to have complete tunnel vision and

    will prefer stagnation and delay to real positive
    action.
    Will savings be called “negative accumulation!”
    How will the millennials, middle aged and pensioners
    outside the DB system react to effectively supporting a
    more affluent retirement for the few at their own cost? I
    suggest that it will stir a very negative reaction.

    Paul Simon

    One trick pony

    JRH

    • Hi JRH

      There are even more rumours of pension cuts in the DB system. This is from the Daily Mirror so needs taking with a pinch of salt but it is not the only place running this story tonight.

      “Plans by the Work and Pensions Committee include letting firms cut the amount they uprate pension income s by each year. Employers could then increase incomes by a smaller amount – or give no increase.

      Pension incomes would cease to keep up with the cost of living, shrinking the amount over a retirement of 20-odd years. Experts predict they could lose a quarter to a third of what they expected.”

      So RPI becomes CPI becomes 0%?

      Oh and nice choice of music. I particularly like that era of Paul Simon’s work…

  3. I am an avid reader of your blog Shaun but have to admit quite a lot of what is discussed is at the limit of my understanding but I know this: when I have had an investment plan for business if the figures stack up (with a margin of safety) I have always gone ahead irrespective of interest rates. These days, with a sizeable cash reserve and no need for external finance, I am sitting pat because there are so many stupid things going on I prefer to avoid extra risk. Am I bonkers or what?

    • I think you sum up the ” problem” that our CB are trying to solve

      you have cash but don’t want to spend because of all the shenanigans going on …..

      I mean who would ?

      Trust ?

      aye there’s the rub

      Forbin

    • Hi clearlydisenchanted

      I just wanted to say that I had seen numbers saying a lot of British forms were like that so I was surprised to read in the FT that companies were heavily indebted. Of course it all depends which company…

  4. Hello Shaun,

    A lot of the actions so far from CB seem to not involve the main street , at least not directly as far as demand / supply . They seemed to be aimed at helping Government with debt and to help make money for Big Banks .

    I think therefore those in the Pensions Industry ( and savers ) are being victimized for the bad behaviour of said Banks

    Is this current round of “stupidity” just really another Bank bailout ?

    How many more do we need before anything is done?

    Will the realization from the HMG finally sink in that , at some time soon, they will be sucked into such a deep hole that no money printing (QE ) will help ?

    the problem with debt is that more debt doesnt help ?

    Find out more in shaun’s next episode …….

    Forbin

    PS : I wonder when the penny will drop that the current WIZZO (TM) solutions of milking the tax payer ends when the tax payer cannot afford the repayments?

    • Hi Forbin

      This may indirectly help the banks but the real winner for them will be the Term Funding Scheme. That has yet to be finalised which raises a wry smile as it was supposed to be so urgent! I guess central bankers holidays are more urgent to them.

      We have this from the Inflation Report though.

      “However, as interest rates are close to zero it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates. In order to mitigate this, the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate.”

      Odd as I have noted a whole row of banks reducing deposit rates recently. Sadly the prospect of the TFS seems to have failed to reach savers like the FLS failed to reach Smaller and Medium-sized businesses.

    • PS : I wonder when the penny will drop that the current WIZZO (TM) solutions of milking the tax payer ends when the tax payer cannot afford the repayments?

      Not until the taxpayer can no longer afford the repayments, so a long time yet…..

  5. One of the dangers of buying corporate bonds is that instead of using the money to invest they will just buy their own shares. If, as a CEO, your bonus is linked to share price the temptation to buy your own shares must be irresistible. The law of unintended consequences is always there..

    • or intended – payoff to our corporate overlords?

      Or really just so the Banking sector can do a buy back

      RBS of public shares ( knocked down discount as well ) maybe?

      Forbin

  6. Hi Shaun very informative as usual.
    Debt it seems is the only tool the central bankers seem to have
    I think the root of our problems are the monetary system,it requires more debt in perpetuity.
    All fiat currencies in history have failed they do not fulfil a basic function of money they are not a store of value,therefore the payment of interest is essential.
    If you had put £1000 under the floorboards in August 1971 you would have lost most of your purchasing power in contrast if you had used your £1000 to buy gold @ 35 dollars a Troy ounce with an exchange rate of $2.40 to the pound you would have been able to buy 68.5 ounces of gold giving you £70000 today.
    Gold real money versus paper no contest this is due to fact paper money is debt driven and does not store value.

    • Hi Private Fraser

      You example made me wonder what the official inflation measure has done since August 1971. It has been rebased a couple of times along the way but by my calculations you would need £12,833 to match it. Therefore your gold investor has made a good real return but the cash investor has had a night mare.

  7. Low interest bonds, bought at high price. A sinking currency. What could go wrong ?

    A smart bond investor would not touch them with a bargepole. But a salaried bureaucrat is deciding to buy them. Just where is the Office for Budget Responsibility ?

  8. Hi Shaun – “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……”

    ECB are only buying Euro denominates bonds issued by EU countries. Given the uK has voted for Brexit I really don’t see the ECB co ordinating purchases of UK head quartered companies bond issuance when said country is suopposedly leaving (although it’s anybody’s guess as to when May is going to get her finger out and actually do it, which in turn is creating more uncertainty amongst investors) so I don’t understand what you’re getting at?

    Reason I know this is cos I read the ECB announcement in April carefully, then bought a Threadneedle Corporate bond fund investing in Euro denominated corporate bonds issued by European companies because of the ECB announcement back in April. A bit of a roller coaster ride followed as expected but my how it took off form early June when the ERCB cranked up – 12.5% since June 1st but only 10% for me since early April but I’m happy enough and expect more upside for quite some months yet.

    It was always the case that in a demand deficient economy cheaper borrowing was simply going to encourage corporations to roll debt exchanging it for cheaper debt, share buybacks or M & A activity which is another trend I’m looking for as it would provide support to European equity markets, suggesting new opportunities, although it will serve no useful purpose for the real economy,employment and the consumer,

    Quite how Mario et al can’t see that when I can is beyond me so I content myself with gaming the Establishment, making money off them and I do so like to game them and stick two fingers up at them!

    • Hi Noo2

      Thanks for the detail on the ECB corporate bond QE purchases which raises a smile as we are after all still in the EU albeit presumably on our way out. However I take your point and will add a note above but there would presumably be implicit gains as funds would buy the UK company Euro paper as they could get more yield from it.

      I am glad that you are making money out of this.

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