When the European Central Bank (ECB) announced its plans to launch the Corporate Sector Purchase Program (CSPP), the credit-investor equivalent of Andre the Giant belly-flopped right into the centre of the market’s swimming pool. In expectation of a large, deep-pocketed buyer hoovering up bonds, credit markets reacted exactly as expected: European spreads rallied. However it wasn’t until last week that the market was given a more precise sense of the timing, scale and scope of the CSPP. Now we have a better sense of the profound implications for global credit markets.
When exogenous factors drive credit spreads, valuations become distorted, trading liquidity thins, borrower behaviour can turn more aggressive and delineations in total return from various regions become more pronounced. Before we explore how the CSPP has exerted such an impact, let’s run through its major parameters:
- From June 2016, the ECB will coordinate monthly purchases of corporate credit instruments with at least one investment-grade rating in both primary and secondary markets, through the capital markets activities of six central banks across Europe
- Eligible instruments include:
- Debt issued by EU member states. However, debt issued by non-EU member states can be purchased if it is issued in euros and by an EU-domiciled entity
- Instruments with a minimum remaining maturity of six months and a maximum remaining maturity of less than 31 years
- Banks are excluded from the program, but qualifying securities from insurance companies are included
Based on these and other criteria (read the full list here), various sell-side analysts estimate that the size of the swimming pool could be €620bn–€650bn. In sympathy with Archimedes, credit market participants gave a collective cry of “Eureka!” when they realised just how much water would be displaced by the CSPP. Anticipating that the ECB would further loosen the quantitative easing (QE) tap (among other reasons), European credit spreads rallied into the bank’s 10 March statement, but they truly accelerated when the CSPP was announced on the same day. On 1 March, the ITRAXX Main and Crossover indices were 96 and 388 respectively. By the end of the month, they were 72 and 303 and have broadly remained at these levels. We believe that they have exceeded fair value, spurred by technical market forces rather than credit fundamentals.
From here, European spreads can only rally so much relative to other regions, and risk falling faster than they can rise – a concept known as convexity that shows the asymmetric return profile of credit instruments, and which explains why we now prefer emerging markets and the US over Europe. At current spreads, the US and emerging markets have greater potential to outperform Europe on valuation grounds and for the reason that global investors will eventually look for opportunities in these markets after tiring of over-bought Europe.
Also, the technically-driven rally in Europe implies that investors have lost sight of fundamentals. Despite relatively unchanged conditions for European credit markets this year, the investment grade CDS index is now around 230bps inside of the CDS Crossover index. This is substantially tighter than the -273bps average for the year, with largest move being the 45bps of compression in the days on either side of the CSPP announcement.
Impact on liquidity
We believe that this rally indicates that investors expect the CSPP to compound an already poor liquidity situation in secondary markets. When markets are running strong and managers cannot buy physical credit, they seek proxies like CDS indices.
As it turns out, the solution to the Andre-the-Giant impact is to simply build a bigger swimming pool: with scarce secondary supply, rapidly tightening credit spreads and the approach of a large, deep-pocketed buyer, now is an ideal time for companies to issue primary debt. And that is what has happened since 10 March, and what we expect to keep happening given the details of the CSPP released last week.
Generation easy debt
In the meantime, credit managers are happy to put cash to work ahead of the crowding-out effect of the CSPP in secondary markets by placing orders in the primary market. At the end of the day, the mispricing of credit risk and the surge in supply introduces several risks for European borrowers. First, just as nature abhors a vacuum, corporate treasurers hate to miss an opportunity to acquire cheap credit. This could lead to poor M&A decisions or other, more shareholder-friendly activities. Either way, we would expect the re-leveraging of balance sheets from trough levels to continue.
It also means that some high-yield issuers will either refinance or increase their overall debt levels, or do both. For some of these companies, this could simply mean staving off a default so they can die another day. After years of easy credit, we believe that some companies have been able to artificially extend their useful lives, and we therefore expect recovery rates to continue to decline – something that does not portend well for CCC-rated credit issuers.
After assessing details of the CSPP and gauging the market’s response, our conclusions are as follows:
- Europe has priced through fair value due to the impact of the CSPP, an exogenous factor. As the market recognises this, global credit investors are likely to look for opportunities in other regions
- We believe that US and emerging market credit will continue to outperform Europe this year. Although default rates in the US will likely rise, those in Europe should remain benign
- However, after years of QE-driven easy money, recovery rates will ultimately be a lot lower as any residual value would be gone as these collapsed companies had been sustained by easy credit rather than merit
- We will be wary of any mispricing of credit risk due to the technical factors noted above and the re-leveraging of balance sheets.
During this technically-driven land-grab for credit and yield, it is easy to lose sight of fundamentals. Ultimately, to generate alpha and to avoid losses, we believe fundamentals and ESG risks must be appropriately priced in.
 “Credit notes: ECB clarifies details on the CSPP: Positive for our compression view” published by Goldman Sachs Global Macro Research on 21 April 2016, and “CSPP eligibility criteria”, published in European Credit Weekly by J.P. Morgan Europe Credit Research on 22 April 2016.