FAQ: ECB’s Corporate Bond Buying Program Starts

In March, the ECB decided to increase its asset purchases from 60 to 80 bln euros a month and to include corporate bonds.  The corporate bond buying program begins this week.   We use an FAQ format to discuss the key issues.

What is the ECB doing?   The ECB will buy euro-denominated, investment grade bonds from companies incorporated within the eurozone.

What is the duration of the corporate bonds that the ECB will buy? 
The ECB will purchase bonds that mature in six months to 30 years.

Will bank bonds be included?  Bank bonds are specifically excluded from the ECB’s purchase program, but insurance companies are included.  Bonds issued by auto companies, for example, that have financial arms with banking licenses, will be included, provided they meet the other criteria.  Also, bonds of companies whose ultimate parent is based outside of the EMU can be eligible for purchases by the ECB provided that the issuing entity has an investment grade rating by at least one designated rating agency and is based in the eurozone.

Will the ECB make its corporate bond purchases in the primary or secondary market? The ECB is relying exclusively on the secondary market for its purchases of sovereign and agency bonds.  The corporate bonds will be purchased in the primary and secondary markets.  In the primary market, banks typically are underwriters and distribute the bonds to investors with companies often making the ultimate decision.  Companies may have different attitudes about the ECB’s purchases. In the secondary market, makes are market makers, buying and selling.

How much will the ECB buy?  It is not immediately clear how much corporate bonds the ECB will buy.  The increase 20 bln euro increases in purchases the ECB announced in March are not expected to be fully accounted for by corporate bonds.  That would seem to suggest the ECB is not as concerned as some investors about running out of eligible paper.  Given various considerations about the size of the European corporate bond market and of individual issues, most estimates suggest a range of 5-10 bln corporate bonds a month may be bought.  We suspect the upper end of the range may be difficult to achieve on a sustained basis.   Look for a rolling start, by that we mean, that the ECB may begin with a small size in a few issues.   The ECB’s rule currently allow it to hold now more than a third of any sovereign’s debt, but it can own as much as 70% of a corporate issue.

What will be the impact of the ECB’s corporate bond purchases?  That is the million euro question.  There have already been two responses.  First, the yields on corporate bonds have fallen in relative terms (to sovereign yields).  Second, there has been increased issuance of corporate bonds.  We note that these generalizations apply to non-investment grade and US corporate bonds as well.    European businesses typically rely more on bank loans than bonds for capital.  Small and medium-sized businesses, which is what the ECB would likely to help, are not typically significant user of the bond market.  Large European companies do not appear to have strong financing needs, given the slow growth and liquid corporate balance sheets.  In addition to the corporate bond purchases, the ECB will also launch another round of targeted long-term repo operations (TLTRO) can banks can secure cheap, and possibly negative yielding funds, from the ECB to lend to households and companies.  ECB corporations may use the cheap funding for merger and acquisitions and share buybacks.

Can the ECB purchase negative yielding corporate bonds?  Although no European corporate bonds have been issued at negative rates, as some corporate bonds get close to maturity, negative yields have been seen in the secondary market.  This includes bonds issued by Johnson & Johnson, GE, LVMH and Philip Morris, for example.  Some industry estimates suggest that around 40 bln euro of corporate paper have negative yields (vs. negative yield on several trillion euros of sovereign bonds).  Negative yielding corporate paper, which meets the other criteria, can be bought by the ECB provided the yield is not less than the deposit rate (minus 40 bp).

What is the impact on US corporate bonds?  US corporate bond issuance has increased, and the premium over Treasuries has fallen.  Foreign investors have been moving into the US corporate bonds market.  A decade ago, foreign investors reportedly owned about a quarter of US corporate bonds.  Now they hold a little more than a third.  US corporates have been issuing euro-denominated bonds. They issued a record amount last year and are on a similar pace this year.