Like Alice when she fell down the rabbit hole, Europe’s bond investors find themselves in “curiouser and curiouser” terrain. That’s because souped-up ECB bond-buying is creating confusing new oddities—plus potential risks and opportunities.
Increasingly strange trends are emerging across Europe’s bond markets as the European Central Bank (ECB) ramps up its quantitative easing (QE) program. What are these topsy-turvy trends? And how can investors avoid getting wrong-footed in Europe’s bonderland?
More and more investors are paying to lend to Europe’s governments. Since April, the ECB has added an extra €20 billion in bond-buying to its monthly QE program. This has driven regional government bond yields down to further extremes.
German Bunds have negative yields out to eight years. And Spanish and Italian sovereign debt, which priced in high default probabilities as recently as 2012, are trading with negative yields at the short end of the curve. These bonds offer the less-than-enticing prospect of return-free risks, with the risks being that their stratospheric prices won’t go on rising.
Price upside potential can be wiped out very quickly. Last spring, investors holding Bunds saw months of price gains wiped out in days when many tried to sell at the same time amid concerns that the ECB might be about to rein in QE.
Instead of viewing QE as a one-way bet on rising prices, think twice about government bonds whose return potential relies on the prospect of price gains. Focus instead on higher-yielding assets whose income cushions offer a buffer against any hits to capital returns if turbulence strikes again.
Credit markets are pricing in a bond-buying bonanza. From June, the ECB is adding investment-grade corporate bonds to its QE buying basket. It wants to drive down bigger companies’ borrowing costs, hoping that, over time, this will help smaller companies borrow more cheaply.
ECB QE has ensured that spreads on much of the region’s peripheral sovereign debt have snapped back, Anticipation of an ECB corporate bond buying bonanza has seen a similar dynamic unfold in credit markets, with some credit spreads well and truly crunched.
Corporate bond issuance has picked up sharply and the premium for new paper versus existing bonds has been eroded as appetite for new issuance has grown. Yields have fallen and the gap between corporate and government bond yields has been squeezed.
Are markets getting ahead of themselves? Details of exactly which corporate bonds—and how many—the ECB is going to buy remain sketchy. We’ll probably only get the full picture in hindsight. Around €400–700 billion of corporate bonds are eligible—around a third of Europe’s investment-grade corporate universe.
But actual buying levels could be much more modest. In Wonderland, Alice wolfed down a cake because it had a big “EAT ME” label on it—with alarming consequences. If the ECB’s corporate-bond quota disappoints, investors who’ve indulged in uncontrolled credit bingeing might also end up with big regrets.
Attractive buying opportunities are opening up as some bonds get the cold shoulder. We already know ECB corporate-bond buying will exclude some types of corporate bonds and issuers. At least 50% (maybe more) of Europe’s credit universe will be left out in the cold.
The ECB says buying will be confined to “nonbank corporations established in the euro area”. That’s a pretty broad definition because it’s hard to classify the natural home of some multinationals. Some British bonds fit the ECB’s criteria—as do a few reverse Yankees (euro-denominated debt issued by US firms).
In any event, a big slice of Europe’s total corporate bonds won’t qualify, with bank bonds the most significant rejects. A widening credit spread gap is opening between potentially eligible bonds and the rest.
This has absolutely nothing to do with these bonds’ credit fundamentals. Weird, but good news for investors who can buy bonds on the basis of their perceived intrinsic value—not just because the ECB might buy them in future. The wide range of yields on offer across the corporate-bond universe means that there are plenty of attractive buying opportunities outside the most expensive names (Display).
ECB support for credit markets is making it trickier to trade credit. Europe’s corporate bond market is neither liquid nor huge. As the ECB moves into the market as an important new buyer, the limited supply of bonds fitting its eligibility criteria is going to get scarcer still. So, with even a relatively modest amount of ECB buying, expect corporate bond trading to get even trickier.
In this bonderland, pinch yourself if you feel you’re dreaming—make sure you’re buying bonds on the basis of their underlying fundamentals. Watch out for fairy-tale prices. And before you rush down any rabbit holes, make sure you can find your way out again.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.