The Corporate Bond problem at the Bank of England

It is time to once again lift the lid on the engine of Quantitative Easing especially in the UK. As a I pointed out several weeks ago the ordinary version where sovereign bonds are purchased has reached its target of £435 billion ( to be precise £39 million below). However corporate bond purchases are continuing under this from the August 2016 MPC (Monetary Policy Committee ) Minutes.

the purchase of up to £10 billion of UK corporate bonds

This was to achieve the objectives shown below and the emphasis is mine.

Purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases. In particular, given that corporate bonds are higher-yielding instruments than government bonds, investors selling corporate debt to the Bank could be more likely to invest the money received in other corporate assets than those selling gilts. In addition, by increasing demand in secondary markets, purchases by the Bank could reduce liquidity premia; and such purchases could stimulate issuance in sterling corporate bond markets.

Okay let me open with the generic issue of whether this is a better version of QE? This starts well if we look at the US Federal Reserve.

The FOMC directed the Desk to purchase $1.25 trillion of agency MBS ( Mortgage Backed Securities)……..The goal of the program was to provide support to mortgage and housing markets and to foster improved conditions in financial markets more generally.

Later it bought some more but here we see a case of a central bank buying assets from the market which was in distress which was a combination of housing and banking. We can see how this had a more direct impact than ordinary QE but applying that to the UK in 2016 has the problem of being years too late unless of course the Bank of England wanted to argue the UK economy was in distress whilst growing solidly in August 2016!

This is a clear change of course from Mark Carney as the previous Governor Baron King of Lothbury was not a fan and whilst the Bank of England had a plan for corporate bond QE in theory in practice it just kicked the ball around for a while and gave up. Why? Well as I have pointed out before the market is small because UK businesses are often international and issue in Euros and US Dollars so that the UK Pound market is reduced. This leads to the Bank of England finding itself having to purchase bonds from foreign companies and this week it is back offering to buy the bonds of the Danish shipping company Maersk.  No doubt it and Danish taxpayers are happy about this but I do hope one day we will get a Working Paper explaining how this boosts the UK economy more than ordinary QE.

The technical view

There are some suggested examples in the Financial Times today from Zoso Davies of Barclays.

Initially, this seemed to work. August and September 2016 witnessed a flurry of new deals in the sterling corporate markets despite the uncertainty created by the UK’s vote to leave the EU. Since then, however, companies’ interest in borrowing in sterling has fallen to levels similar to those seen in 2013 and 2014.

As you can see once the “new toy” effect wore off things seem to have returned to something of a status quo. The “new toy” effect was exacerbated because the borrowing was so cheap.

Borrowers have also benefited from somewhat better terms on their bonds. After the initial announcement, sterling credit spreads (the additional yield risk borrowers must pay relative to the UK government to borrow in sterling) came down sharply.

If we look back we see that not only did the UK ten-year Gilt yield drop towards 0.5% but the spread above it corporate bond issuers had to pay fell, so there was a clear incentive to borrow. The catch is that if we recall the “lost decade(s)” experience of Japan the link between that and productivity activity tends to fail. One rather revealing fact is that the article does not mention real economy benefits at all instead we get this.

Our analysis, based on the limited data available for corporate bond markets, suggests that trading activity has not picked up across the sterling market as a whole, implying that the Bank of England has been crowding out other market participants. That said, the evidence is far from convincing in either direction.

The price effect did not last either.

Since then, however, the sterling market has hardly moved, indicating that most of the market impact came from the announcement rather than their execution. And that lack of movement has been a marked underperformance versus dollar and euro credit markets, to the extent that sterling has returned to being a relatively expensive bond market in which to raise financing.

Of course we have a tangled web here because one of the factors at play is the the 208 billion Euro corporate bond purchases of the ECB have allowed some companies to be paid to borrow, or if you prefer issue at negative yields. This is from Bloomberg in January.

Henkel AG’s two-year note issued at a negative yield

Also its activities make us again wonder who benefits? From Credit Market Daily.

A big theme in 2015-16 was the amount US domiciled corporates funded in the euro-denominated debt markets. As shown in the chart above, it was a record 26% of the total volume in 2015 and 22% in 2016. Low rates everywhere, but lower in Europe along with low spreads made it attractive for US corporates to borrow in euros (even when swapped back to dollars)

So the Bank of England is supporting European corporates and the ECB US ones? Time for Kylie.

I’m spinning around
Move out of my way

The article ends with some points that pose all sorts of moral hazards.

If sterling corporate bond issuance collapses and secondary market volumes plummet, it will be clear that the Bank’s newest tool has been propping up this small corner of the fixed-income universe over the past six months. Conversely, the more graceful the exit from corporate bond buying, the less clear it will be that the CBPS has been much more than a placebo for markets.

So if borrowers want to borrow cheaply just go on an issuers strike? Also what if the lower yields have sent other buyers away and crowded them out? That would have created quite a mess.

Comment

There are a lot of issues here. Lets us look at the real economy where are the arguments that it has benefited? Whereas on the other side of the coin we can see that subsidising larger companies both ossifies the economy and would help stop what is called “creative destruction”. Whilst the productivity problem began before this program started is it yet another brick in the wall for it via the routes just described? As the Bank Underground blog puts it.

Since 2008, aggregate productivity performance in the UK has been substantially worse than in the preceding eight years.

Also whilst the Federal Reserve purchases of MBSs seems to have been a relatively successful version of QE we have to add “so far”. This is in the gap between the word “stop” and “end” as whilst it stopped new purchases it maintains its holdings at US $1.75 trillion. How can it sell these and what if there are losses which could easily be large? Will the Bank of England end up in the same quicksand? Frankly I think it is already in it.

Yes equity markets are higher but the one area in the UK that has surged in response to this extra monetary easing has been unsecured rather than business credit.

 

 

 

Advertisements

33 thoughts on “The Corporate Bond problem at the Bank of England

  1. The only explanation for this mess is that these central bankers spend too much time in their own company. They need to get out more and think clearly. I would like them to answer the following questions:

    1. How could they possibly think that we should use BoE “money” to buy bonds issued by Maersk?
    2. What is this corporate spree intended to achieve? Where is the evidence that it is being achieved?
    3. How is it going to be reversed?
    Amazingly (and, I think, uniquely), these bond purchases are not a device to rescue the banks. So, why are they doing it?

    • James, You are absolutely correct in your statement that central banks ‘spend too much time in their own company’ I would thoroughly recommend the book ‘Fed Up’ by Danielle DiMartino Booth a former fed insider who demonstrates how central bank policies are arrived at by Econ PhD’s who believe unquestioningly in their own economic models and have zero real world experience. Some of the examples she gives are truly frightening.

    • 1. They failed to grasp that whilst there was a relatively low risk of default on the public funds they were putting into this, most Ftse 100 companies (whose bonds they pledged to buy) are of foreign domicile and generally issue in their native domicile currency.

      2. Drive the cost of borrowing generally down, which it achieved with unsecured lending although not with corporate business.

      3. Why should it be reversed? It can be allowed to cancel off as the bonds mature. If you are hell bent on reversal as you seem to be then you wait for teh marketto strengthen (one of the aims of the policy) and then gradually sell your holdings back into the market.

  2. Shaun,

    Is the use of corporate bond funds for share buybacks increasing share values and thereby maintaining fat cat salaries & bonuses etc?

    I think now in the US we are entering the reporting season when share buybacks halted so let’s see what happens!

    • Hi chris

      That is pretty much impossible to prove . But in the same way that conventional QE gives a windfall to national treasuries and politicians this gives the same to company treasurers and directors. In particular the ones of larger companies which is where we are left thinking that whilst I cannot prove it is hard to escape the feeling that the answer to your question is to some extent yes.

  3. I think there is a general belief in central banking circles that doing something is better than doing nothing. Given the complexity of economics and finance it might be better if those attempting to manage our economy looked at it from time to time and admitted that they don’t really know what is going on. Once they had reached this enlightened state they just might be able to conclude that doing nothing is actually preferable to doing something.

    • Absolutely spot on. Why, for example, don’t they reserve their firepower for a real emergency, rather than a weird attempt to cut Maersk’s borrowing costs?

      • They aren’t accountable so they can do whatever they want whether its a real emergency or not, so long as it keeps the plates spinning when they’re in control.

        Only have to look at the way Carney ran rings around May then dropped rates and printed some more only weeks after she stated its creating an ever increasing wealth gap.

    • “Given the complexity of economics and finance …”

      actually economics is quite simple – the Banks make it complex !

      making up terms, poking this , wiggling that , generally going around stating that “its far too complex for mere mortals to understand”….. and so on .

      basically , we’ve borrowed too much , and the only plan that a Banker can think of is to borrow some more

      then lets someone else pay for it ( tax payer normally )

      now, how can you justify fat cat salaries and bonuses if mere mortals can do that ?

      Forbin

      PS: our politicians lick their collect lips when thinking about joining the “club” after perjury in the house of commons/lords

  4. Hi Shaun
    No politician, central banker, national or
    international, will ever want to address the 2008
    elephant in the room on their watch.
    If all countries with their own central
    banks can buy each others good and bad “stuff,”
    then the only thing that concerns them is delaying
    reality, so this madness continues the gradual decay
    and currency debasement will rule unless President
    Trump gets his gun out of his holster!
    JRH

    • “More than any other time in history, TBTF Banks face a crossroads. One path leads to despair and utter hopelessness with no bonuses. The other, to total extinction.
      Let us pray they have the wisdom to choose correctly.”

      misquote Woody Allen

      Forbin

  5. The central banks and economists generally have not recognised a systemic problem in the global economic system. The global economy has required huge amounts of capital to build railways, ships, oil refineries, power stations, etc. etc.over the past 200 years. Our capacity to generate savings has continually increased. In recent decades the requirements for capital have been in relative decline. Most large corporations distribute less than half their earnings in dividends; saving the balance. Increasingly new businesses are in the service sector where capital requirements are much smaller. Even in traditional metal bashing industries there have been reductions in capital requirements through the use of new materials and methods.
    On top of all this, governments have been subsidising savings through retirement plans, ISAs, etc.
    The nett result is a very large oversupply of capital. This is really what is driving interest rates down. This is the fundamental. Simple economics 101; interest supply and demand curves.
    The proper policy response is to remove all subsidies to savings and to increase taxes on those with the higher propensity to save; i.e the wealthy. There are many other policy implications but these two alone will suggest why an appropriate policy response is not very likely.
    The long term outcome is difficult to predict (if it wasn’t I would be a billionaire!) but I suggest that the most likely outcome is the destruction of surplus savings by significant inflation. This is just a summary and one day I will write a book. In the mean time just remember that the safest haven for capital in the very long run is bricks and mortar!

    • Hi shakec

      That is an interesting comment but let me first reply with a question, if we have too much capital why are we struggling to fund future retirement plans?

      The problem with the bricks and mortar argument is that it is all booked as wealth gains whereas the truth is that some gain but first time buyers and those looking to trade up are hit hard by inflation which is ignored by official data.

      On the savings point you may like this tweet which I have just noticed.

      ” @RudyHavenstein
      62% of Americans have less than $1,000 in a savings account. Even at income levels of between $100,000 & $149,999, 44% had less than $1,000.”

      • I think he means a large oversupply of government encouraged/stipulated savings out of income (ISA’s, PEP’s, workplace pension etc) directed towards capital by fund managers where advanced nations have moved to service industries and therefore have a lower capital/infrastructure requirement whilst emerging markets like China have already over invested in capital equipment relative to their economic position.

        It is an interesting and thought provoking assertion.

        • Roughly right.
          Oh!, and by the way; my comment on “bricks and mortar” was really a joke. But if the financial system had a real meltdown as ,say, in Wiemar Germany the only thing left might be pure physical assets!

      • Dear Shaun. This is a problem arising from confusing the real economy with the financial. Try a little thought experiment.- 30 million workers in UK; assume each worker needs a pension fund of £200K at retirement (annuity rates close to zero therefore pension of roughly £6K/year -so very modest); with very low interest rates pension fund will be built evenly over working life. Therefore average size of pension pot is £100K. Therefore at any time the total pension pot will be 30,000,000 times 100,000; i.e. 3 trillion pounds.This is a multiple of the total value of productive assets in the UK (not counting housing). Include housing (at current inflated values) and the required pot would still require half of the total value. Clearly we could never fund, even a modest, universal pension scheme.
        There is in fact no relationship between the total value of the existing productive assts and the future pensions we might choose to promise ourselves.
        In order to focus on the reality of the “real”, physical economy I have ignored other financial issues such as private and public debt.
        Ownership or control of financial assets is dispersed unevenly across the population. The bottom half of the population may have negative financial wealth. Their debts exceed their assets. In fact, a substantial proportion of the financial assets of the top half are comprised of debts due from the bottom half, but these are all financial issues.
        Speaking of financial assets; very significant financial assets exist in pension plans. About 60% of the working population have an occupational pension plan. These amount to a very large sum; I forget the actual amount but the figure of 1.6 trillion comes to mind but don’t quote me on this.
        In principle the state pension liability is a financial asset for those that pay national insurance. By a very convenient convention economists rarely count state pension plans as state liabilities.
        In short the proportion of the national income that we save should be that which is required by the government, industry,and commerce for investment in the real economy. The interest rate is the pricing mechanism for ensuring that only the needful amount is saved.
        I find you blog very interesting because it frequently casts a fascinating light on the relationship between the real economy and the financial one.
        Kind regards Charles

    • Do stick with us a few weeks and see if you can continue with your position? Does printing money create capital for instance? We are always ready to hear some challenge. 🙂

      • The real economy produces,each year, a quantity of goods and services which are either used for current consumption or spent by government snd the private sector on investment in real physical assets.
        In simple terms the financial economy describes the arrangements for distributing assets and income through the population at large. The interest rate is a mechanism for arriving at an appropriate split between current consumption and investment. Arbitrarily increasing the money supply (printing money), when the economy is in equilibrium, does nothing but increase prices generally. i,e, inflation. If there are unused resources in the economy then increases in the money supply will result in these resources being used and overall output increasing (a la Keynes).
        Of course in real life there are many complicating factors but there are fundamentals which always apply in the longer run.

        • A reply to your comment @ 6:05 pm on 4 April. I guess it all depends on what you mean by “not very big”.

          Given the total market capitalisation of the Ftse all share is £2 trillion, the S & P 500 is $21,351,504.0 million, the CAC is €1,200 trillion, the DAX €1,000 trillion,all valuations approximate and all markets where you would reasonably expect to find ISA/PEP investors situated ignoring emerging markets capitalisation values and global bond markets both sovereign and corporate I do believe that £518 billion is not very big in the overall financial scheme of things.

        • One other thing, as the workplace scheme is compulsory, over the long haul it will dwarf the voluntary ISA’s/PEP’s.

        • Yes, the scale of pension plan savings certainly adds, in a major way, to the problem.

        • Your comment @ 10:03 on 4 April refers. A very good point about foreign schemes similar to ISA’s. I completely forgot about them! So now amend my comment about ISA’s being not very big to being substantial.

          Investment funds with a useful physical destination? Some is useful but a lot isn’t, as evidenced by the divorce between asset markets and the real economy which leads, as you have said, to ever falling interest rates/rates of return on investment(ROI) and expanding Price/Earnings (P/E) ratios of the various markets.

          QE simply exacerbates the problem although it helps liquidity when investors get scared. The trouble is I don’t believe the BOE extra QE last year was required and maybe not the ECB ongoing QE, although that carry’s the caveat of wondering what the exchange rate of the € would be now? Perhaps £’s to the €?? with the associated fallout for the economies of the EZ.

    • Increasing taxes on the wealthy, current politics is disinformation and oligarchy with goal for the very rich to pay zero rate. Merely making the wealthy pay minimum 25% would hugely increase the tax take. Corrupt tax avoidance is the problem I see. The middle class pays a much higher tax rate.

      And for your assertion on savings – where are they ? We have bad debts propped up by QE, ZIRP etc. We have insolvent banks and heavily endebtted governments. The only excess savings are invisiblely held by evil thieving lying oligarchs.

      • I think fundamentally shackec is right. The corollary is that we are in a secular deflationary environment on a global basis and I think this is correct, despite the current resurgence of inflation.

        We have had thirty or forty years of aggressive globalization; we now have substantial surplus capacity and aging populations who consume less. This is an environment with surplus savings and a tendency to deflation.

      • I can see your argument on lack of savings when considering ISA’s and PEP’s as they aren’t very big in the overall scheme but the work place pension is something else.

        A compulsory payment made to an organisation which then invests it. That’s savings on a big scale. I formed the opinion when first hearing of the work place pension that it was a cynical way of the Government obtaining financing of it’s debt via the backdoor as most Pension funds buy lots of Gilts alongside corporate bonds with some shares thrown in. In making the scheme compulsory the Government guarantees itself a minimum amount of demand for it’s gilts which helps towards price increase and coupon reductions for the forseeable future. All this is done with compulsory savings deducted from the worker before s/he sees it whether or not they can afford the payment!

        • The total market value of ISA’s and PEP’s at the end of last year was £518 billion; not sure I would term this as “not very big”.
          As to motives of the government; I only wish our policy makers were that smart. What is clear that tax relief on any kind of savings subsides the savings of the well off at the expense of the poor. Hard to justify on any basis.

        • Total of ISA £500 billion is roughly 25% of footsie value you quoted; by any measure significant; especially considering the foreign ownership proportion of Footsie. Similar schemes in the US dwarf UK figures; let alone Japan, Germany, etc. We havn’t even started to consider the volume of “hot”money circulating in the world economy; some estimates in the region of $40 trillion. Who knows?
          The discussion is about whether the total funds available for investment globally have an useful physical destination. What is your view?

    • As Columbo would say: Just one more thing – I’ve been looking at this – https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/547217/Full_Statistics_Release_August_2016.pdf. table 9.6 refers, it appears that of the £518 billion of ISA’s only £267 billion approximately is invested in stocks and shares with the remainder in cash.

      It is the stocks and shares ISA’s which I am concerned with when considering “savings rates” i.e. money saved and intended to be invested in asset markets, so the “problem” would only seem to be half what I originally thought although it is still sizeable.

      • I am not sure here, but this may be a problem connected with consolidation of PEP’s with ISA’s. I believe there may have been a loss of detail; and in fact the “cash” may be stocks. It really needs an enquiry to ONS to establish what is really the case.

  6. Seems like a slightly circular argument to me. The main reason people consume less when they retire is that they have insufficient savings (including pensions) combined with an uncertain demand on those savings, i.e. basic insecurity. Of course in (hopefully much) older age these savings will be spent on health and/or care services, and eventually whatever is left will either be passed on to younger consumers or retained by the financial industry.
    On a slightly more cynical note, any negative effects of large amounts of money belonging to the hoi polloi could be considered a short-term problem in a world of financial innovators.

    • People don’t consume less upon retirement, or they might in the early years but then consume more in their later years as they make extensive use of the NHS consuming it’s services which have already been prepaid but which generally, they made scant use of in their younger years.

  7. There is a continuing confusion of the financial system and the real economy. It is irrelevant who consumes the output of the economy; the problem arises when the supply of savings exceeds the capital requirements of government and capitalists. The greater the excess of supply the more the price (interest rate) drops. Because of a number of factors (subsidisation of savings, higher propensity of the well off to save, lower capital requirements because of technology, etc.) we have an enormous surplus of savings. This is a relatively new phenomenon so it is not surprising that policy makers are not familiar with this; and do not have established routines to deal with the situation. Most economists have not even thought this issue though yet. The policy requirements are fairly straight forward but will be politically explosive. So we will continue to muddle on. I am having difficulty in incorporating these factors into my economic models so my outcomes are subject to a great deal of uncertainty.
    But I will add this: For three hundred years no reasonable person had any fears that a British Government might repudiate its debts; not even in 1919 and 1946. I have had no conception of this for decades until recently. I now believe that there is a possibility, albeit a small one, that this might come about in my lifetime. A dismaying prospect.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s