08 Juin 2016

When the ECB announced a significant policy package last December, the market was disappointed and many stated that the ECB had lost its magic. This feeling was reinforced with the market selloff experienced in the subsequent weeks. In contrast, the next package announced in March exceeded market expectations, especially with the inclusion of IG-rated corporate bonds in the QE programme and some new TLTROs. All of a sudden, the ECB’s magic seems to be back as credit markets have rallied strongly since, even though much of the price action can also be attributed to an improving outlook for the US economy and various commodity markets, as well as the decent performance of European banks during their Q1 2016 results. Going forward, the poor inflation outlook in the EZ and the never-ending concern of creating some unwanted tightening in financial conditions will likely lead the ECB to extend the current QE programme beyond its term of March 2017, in our view.


So, it seems that we are well entrenched in an addictive spiral at the moment where any disappointment on the level of support and of liquidity provided by the ECB necessarily creates some negative price action and raises the prospects of tighter financial conditions, which could in turn derail the current economic recovery of the region. With close to 50% of the EZ govies market trading at negative yields, IG borrowers printing new bond deals in the 0.5%-2.0% range and the ECB refinancing its banks in almost unlimited quantity at a 0% cost, it is hard to argue European credit markets are not currently experiencing extraordinary and potentially highly vulnerable conditions. However, that doesn’t stop the market to react positively to any new shot in the arm from the ECB as evidenced by the strong rally of European credit since the trough reached in mid-February.


“Damned if you do, damned if you don’t” seems to be the current fate of the ECB. At least until Europe reduces its high leverage – public and private – and restores a much stronger and sustainable economic growth, which would allow credit markets to function properly again without life support from the ECB. Should those goals be achieved, the ECB may then be in a position to stop providing the market with its addictive liquidity and potentially even to start a complex and dangerous unwind process. But far from being close to this juncture, European credit markets are about to begin a new addictive ride with the inception of the Corporate Sector Purchase Programme (CSPP) on 8 June.


Interestingly, it seems that the portfolio rebalancing effect created by the ECB CSPP has started even before the ECB purchase of corporate bonds. The trend is obvious in the IG market of course where spreads tightened on the back of the ECB March announcement and primary issuance has been very high. But it is also in HY where after 3 quarters of anemic volumes of new issues, the primary market is firing all cylinders. It is worth noting however that such bullishness has mostly been concentrated on the BB segment of the market where traditional IG investors have now become active both in primary and secondary with two main motivations. First, for the search for yield, which makes a BB-rated senior secured corporate paper yielding ca. 3% an attractive value proposition on a non-risk adjusted basis relative to most IG bonds. Second, because of the fear of being crowded out from the IG primary market – the latter being expected to be a major source of supply for the ECB – which creates a need for IG corporate bond substitutes such as newly-issued BB-rated assets.

In this context, the spread decompression in HY and in banks has not fully retraced. As a result, we continue to see attractive pockets of value in certain lower-rated situations which pricing has not been distorted by the QE-driven portfolio rebalancing effect. The same also applies to bank hybrid capital now that several technical aspects of the AT1 instruments are being clarified and the Q1 2016 earnings season of European banks alleviated fears that asset quality and capital could be under pressure going forward. On the opposite side of the spectrum, we see an increasing number of IG names trading at levels which are inconsistent with their credit dynamics and outlook – a fertile ground for future shorts in our view.


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