The Bank of England’s corporate bond-buying programme follows the path of its European counterpart’s initiative. The short-term impact on credit-market performance has been remarkable, although risks still lurk for those investors who indiscriminately run to yield.
New buyer on the block
In early September, the Bank of England (BoE) will launch the Corporate Bond Purchase Scheme (CBPS) as one tool in a set designed to mitigate economic pressure that could follow the decision of a small majority of British voters to quit the European Union. Through the scheme, the BoE intends to purchase up to £10bn in corporate bonds of non-financial companies with at least one investment-grade rating, over a period of 18 months. In its own words, the purpose of the CBPS is to “impart monetary stimulus by lowering the yields on corporate bonds, thereby reducing the cost of borrowing for companies”.
This, in turn, should stimulate new issuance of corporate bonds. And while the announcement of the programme surprised many, the European Central Bank (ECB) had blazed the trail only a few months before with its Corporate Sector Purchase Programme (CSPP), so the swift tightening of sterling credit spreads and flattening of credit curves was like déjà vu all over again (see chart below). In addition, look at credit curves across Europe: much of the front end of corporate credit is trading at negative levels. Following this distortion in valuations, as credit investors we must now decide whether or not we are being paid for the risks inherent in corporate fundamentals, ESG exposure and Brexit, with yields now much lower.
Tighter spreads, lower yields as central bank intervention distorts valuations
Source: Bloomberg as at 22 August 2016
Gauging the impact
First, let's take a look at the impact on credit markets. At £10bn in size, the scheme could absorb approximately 8% of the available credit pool. While this is smaller in scale than the CSPP, which represents approximately 11% of the eligible euro credit market, the CBPS could be more influential because the sterling credit market is shallower and thus less liquid. Meantime, with the front end of investment-grade credit curves now firmly in negative-yield territory (see chart below), pension schemes and insurance companies are required to move further down the credit curve to find yields that meet their needs.
Negative yields at the front of the curve
Source: Bloomberg as at 22 August 2016
Indeed, at the confluence of this hunt for yield and the ability for companies to lock in long-term debt financing at historic lows, we are seeing UK corporates issue long-term debt. Take Vodafone for example. Days before the CBPS announcement, Vodafone issued an £800m bond with a maturity of 2049 and coupon of 3.375% at a credit spread of 190bps over gilts. Less than a week later, after the CBPS announcement and having seen that bond surge eight points in price, it was able to issue an even larger bond at £1bn in size and longer in maturity at 2056 – with a lower coupon of 3% and at a much lower credit spread over gilts of 168bps.
Overvaluations and opportunities
Meantime, because nothing happens in a vacuum, the indirect impact of the scheme has been palpable across debt markets. For example, ‘out-of-scope’ securities have benefited immensely (but not evenly) from the imminent programme. Whereas lower quality high-yield names such as Matalan are trading approximately where they were before the referendum, higher quality names like Virgin Media and Travis Perkins are trading at or above their pre-Brexit levels. Standard Chartered, which is out-of-scope as a banking institution, issued a dollar-denominated additional tier 1 bond that attracted large demand from investors and had the largest order book for such a transaction from a European lender so far this year.
The siren call for yield persists. As a result, valuations in some areas have traded beyond what we perceive as fair value for the fundamental, ESG and Brexit-related risks of companies. That said, the exogenous catalysts of the BoE and ECB programmes will endure. We are finding opportunities at the long ends of credit curves, in other jurisdictions – hard-currency emerging-market debt and the US – and among the capital securities of higher quality companies. Additionally, in the high-yield market, our focus on up-in-quality trades remains and we are avoiding stressed names that are illiquid or require more supportive macro environments to grow into their capital structures. We believe that declining recovery values, as evidenced by the defaults of Oi and Abengoa, imply that downside scenarios will be more malignant than in the past.