After the ECB ventured into the world of quantitative easing as a policy response to deflationary threats and lack of growth in the Eurozone, the markets are abuzz with the latest venture, known as corporate bond purchases starting June 8th. So what are corporate bond purchases how are corporate bond purchases different from regular bond purchases and what impact will it have on the Eurozone economy? This and more questions are answered in this article.
ECB’s QE – Timeline and Context
The European Central bank, embarked on Quantitative Easing when it announced on January 2015 that the central bank would purchase sovereign bonds to stimulate growth in the European economies. While initially starting with a monthly bond purchase program of 60 billion euros, the ECB quickly ramped up their QE purchases by another 20 billion in March 2016, exactly a year since the QE purchases began. Under the current scope of purchases, this amounts to 80 billion euros. By purchasing sovereign bonds, the ECB hopes that its actions will send the bond yields lower and thus euro area economies would be better able to finance their budget deficits apart from already lowering euro area interest rates into the negative to spur lending.
As part of the QE expansion announced on March 2016, the corporate bond purchases start on June 8th, 2016.
What are corporate bonds?
A corporate bond is basically a debt security that is sold to investors (creditors being the right term) from a corporation or a company. Companies issue corporate bonds for many reasons. It could be to raise cash quickly to fund new ventures rather than issue new equity to the shareholders. Corporate bonds typically attract a higher interest rate and in case of insolvency, bond holders are usually given first preference. Corporate bonds can be long term (10, 20, 30 years) or short term (a year or less than a year). Another reason why companies issue bonds is because of the structure. Unlike a shareholder, a bond holder does not own any equity in the company and therefore has no voting rights. Bond holders are also not entitled to any dividends that the company pays. According to Merrill Lynch, corporate bonds sector is the second largest, only next to the government bond markets with nearly 30% of outstanding bonds in the global markets coming from the corporate sector.
Difference between government bonds and corporate bonds
A government bond is a bond or an IOU issued by the national or sovereign government and is denominated in the country’s national currency. For example, the German bonds or bunds are denoted in Euros while the US treasuries are denoted in US dollars. Corporate bonds on the other hand are issued by companies large and small. The main difference between a corporate bond and a government bond is the risk factor. Government bonds are traditionally considered a safe haven as the debt is backed in full faith and credibility of the government that is issuing it. Corporate bonds on the other hand come with a higher risk. Corporate bonds therefore have a higher yield compared to government bonds.
What is the ECB’s Corporate Bond Purchase Program?
The ECB’s corporate bond purchase program, officially known as the Corporate Sector Purchase Program or CSPP is a program targeting purchase of investment grade euro-denominated bonds. These bonds are of course issued by non-bank corporations that are established in the euro area. The CSPP was launched to run alongside the ECB’s Asset Purchase Program which involves buying sovereign bonds. The goal is to ease monetary policy accommodation and contribute to inflation returning to the ECB’s mandated target rate of 2.0%. Under the ECB’s latest publication outlining the rules for buying the Corporate Bonds, any corporation that has activities in the financial sector is in-eligible for bond purchases under the CSPP.
Here’s a quick summary:
- ECB will buy euro-denominated investment grade bonds from companies that are incorporated within the eurozone
- Only bonds with a maturity of more than six months and up to 30 years will be considered uncer the CSPP program
- Any company incorporated in the eurozone even if it has a parent company elsewhere is still eligible to participate
- If the parent company of the debt issuer is a bank, the entity is ineligible
- Bonds being considered under the program should meet the ECB’s collateral eligibility framework
- Bonds with negative yields are also included as long as the yield is above the ECB’s overnight deposit rate of -0.40%
How does the ECB buy corporate bonds?
The ECB will buy bonds in both primary and secondary markets. Primary markets for bonds are where the security is created or sold for the first time. In the primary markets, the security is purchased directly from the issuing company.
Secondary markets as the name implies is where the bonds purchased in the primary market can be sold and even traded. The bond purchases will be made by six national banks including Belgium, Germany, Spain, Finland, France and Italy.
Due to the relatively new nature of this undertaking the ECB said that it will start with buying a few bonds for starters and gradually increase the pace and scope of its purchases. However, the ECB will be publishing every week the amount of corporate bonds it holds or has purchased with details and also assuring that the bond purchases will be market neutral. Analysts speculate that the ECB could end up purchasing as much as 5 billion euros in corporate bonds.
European companies, in anticipation of the corporate bond purchase program already started issuing bonds. For example, AB InBev, the world’s largest brewer, headquartered in Belgium sold the largest euro-denominated corporate bond in March this year with the debt sale having a minimum size of 13.25 billion euro across six different maturities. AB InBev is expected to use the cash raised from the debt sale to fund its acquisition of rival SABMiller.
What impact will the ECB’s Corporate Bond Purchase program have?
At this point in time it is unclear on what impact the corporate bond purchases will have in terms of economic growth or inflation. But pundits have varied predictions on this. Some believe that the ECB’s direct (debt) financing of companies could send the bond yields lower and thus reducing the financing costs for the companies. In anticipation to the ECB’s CSPP program, many US based companies are looking to get a foothold in the European markets to take advantage of the low financing opportunities.
This WSJ report mentions that, in 2015 European companies borrowed 24.7% of their money in the bond markets according to Association for Financial Markets in Europe with the remainder coming from bank lending. Since 2009, the borrowing has increased 18.70%.
While it is still too early to tell how the CSPP will help the average household, the main theme remains that with companies now having access to cheap lending, keep an eye out on the European equity markets in the medium term horizon.
This article from Bondvigilantes has more details on the ECB bond purchase program including a potential list of companies that are eligible under the program, with BMW, Telefonica, Deutsche Telekom a few names from the list as well a possible sector wise breakdown.
Welcome to the next step of quantitative easing!
Links & Resources – Further Reading
- ECB announces details of the corporate sector purchase programme (CSPP)
- ECB adds corporate sector purchase programme (CSPP) to the asset purchase programme (APP) and announces changes to APP
- Next Stop on ECB QE Adventure: $980 Billion Corporate Debt
- FAQ: ECB’s Corporate Bond Buying Program
- Draghi Fires Starting Gun on Corporate Bond Purchases in Europe
- Why the ECB’s Impact On Corporate Bonds Has Been Smaller Than It Seems