Monday, August 29, 2016

The ECB’s corporate bond purchase programme takes shape

Guest post by Marcello Minenna

With the awaited decision of August 4, even the Bank of England has put aside any delay and has steered towards an aggressive expansionary monetary policy to contrast the recessionary pressures due to the Brexit shock on market expectations. Apart from the expected interest rate cut of 25 basis points, different unconventional measures stand out: a 6-months resumption of the government bonds (Gilts) buying programme for a monthly amount of $ 60 billion, to be combined in synergy with the purchase of £ 10 billion of corporate bonds in 18 months.

The intervention in the corporate debt markets remains one of the most incisive tools in the hands of the central banks in order to induce a reduction in the funding costs of the non-financial sector and bypass the credit crunch due to a distressed banking system. At the state of the art, corporate bonds purchase programs are active in Japan, UK and in the Eurozone. On many occasions the Bank of japan has accelerated the pace of the purchases, even if now it appears it has reached its limits of intervention: the size of the market is not ample enough to support further expansions of the program, while the big Japanese industrial corporations are able to finance themselves at near zero interest rates (recently Toyota succeeded in placing a 3-years bond by offering a yield of 0.001%).

In Europe the program is instead in its infancy; at the present state, the room to maneuver is ample. The ECB has started the purchase operations of corporate bonds in June 2016 and only now the first stream of official data has begun to be released; few numbers that however are enough to verify if the first estimates made when the program was launched in March 2016, were at least realistic. According to the numbers published by the ECB, the 93% of the overall € 13.2 billion of purchases has been made on the secondary market, while only the 7% (that corresponds to € 1.16 billion) during the placement of new issues. This is not a negligible amount if we consider the traditional reluctance of the ECB to intervene in primary markets (the Quantitative Easing on government bonds is focused exclusively on the secondary market). From our point of view, this behavior signals a relative scarcity of eligible securities on the secondary market to sustain the planned pace of the ECB purchases.

On the basis of the experience of the Quantitative Easing, we estimated an overall pool of corporate eligible assets of € 550 billion and a monthly purchase ranging from a minimum of € 3 billion to a maximum of € 6 billion, without however taking in account the possible response of the market. In fact, in the hopes of the ECB, the non-financial sector should have increased the issues of debt to take advantage of the launch of the program. In this perspective, the historical records were not so favorable, since they showed a downward trend of the market issues (both gross and net of reimbursements), with a decline that was accelerating in the last months of 2015. In August 2016, we have to acknowledge that the real data of monthly purchases (€ 6.6 billion) lie outside the estimated range, but only for a small amount. Therefore it’s interesting to check if an “announcement effect” of the CBPP program has effectively pushed the non-financial sector to issue more debt. To this purpose, let’s observe carefully the following bar charts that represent the historical trend of gross and net issues of Euro-denominated bonds of Euro-Area non-financial corporations.

Figure 1.

Figure 2.

One can easily notice that starting with the month of March 2016, the big European corporations have increased considerably the issues (from € 30 billion to € 70 billion for what regards the monthly gross issues, from 0 to 20 in net terms). Hence, the good response of the market in the last four months and the consequently augmented availability of eligible assets could reasonably explain the dynamics above expectations of the ECB purchases.

The ECB is clearly aiming at having a positive, durable impact on the financing costs of the non-financial sector, to be achieved through a compression of bonds yields. In fact, the presence of the ECB as a buyer of last resort should provide to the corporations a stable, implied guarantee of a successful placement, a necessary condition to obtain lower yields. Even in this case, we have been able to retrieve useful empirical data to clarify the impact of the “announcement-effect” first and then of the purchases on the yields' dynamics (see Figure 3).

Figure 3.

In Figure 3, the historical trend of the Bank of America Nonfinancial Index from January to August 2016 is analyzed. The index is representative of the average yields non-financial Euro denominated investment grade corporate debt publicly issued in the Euro member domestic market. The observed pattern of the index shows a marked decline after the launch of the program by President Draghi in March 2016, a subsequent stasis and a relapse in the downward trend in conjunction with the start of the ECB purchases on the primary and secondary markets.

Overall it could be observed a reduction in the BofA index (that as said before should roughly correspond to a weighted average of yields of Euro-denominated corporate bonds) up to 90 basis points from the relative maximum registered at the beginning of 2016.

In summary, the first empirical evidence seems to confirm the potentiality of the ECB corporate bonds purchase programme in contrast to the credit crunch, at least in average at a European level. The data seem to highlight a significant responsivity of the new debt issues and of the average yields to the ECB monetary stimulus, which intensity appears to exceed the prudential expectations of the market. However, in the future months, it should be observed if the central bank will be able to continue the purchases at this sustained pace without impacting the market liquidity that remains very thin. Moreover, it’s not granted that lower funding cost for the non-financial sector will stimulate new investments.

On the issue, numerous doubts are still in place: in Japan, the big corporations have used the new liquidity trickling from the monetary authorities to the banking and corporate sector to benefit the existing shareholders, both directly by boosting the dividends and indirectly via buybacks. The buybacks have exploded from ¥ 1000 billion in 2012 to over ¥ 4000 billion in 2015, but visible effects have been appreciated only on the stock markets, where the ETF and corporate bonds purchases have been determinant in sustaining the Nikkei index to high levels. The dynamics of corporate investment have been largely unaffected by the BoJ unconventional measures. Paradoxically, the market rewarded these strategies since a reduction of the floating stocks increases by definition the earning per share. Time will tell. Surely, the small businesses, cut off by Draghi’s CBPP, will continue to endure a persistent credit crunch due to the difficulties of the Eurozone banking system, especially in peripheral countries. This is not exactly encouraging from the perspective of growth in countries where the small-medium enterprises are the core of the manufacturing sector, like Italy.


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What is Behind the Surge in the Corporate Debt

Guest post by Norman Mogil

Just as governments are cutting back on issuing new debt, the corporate sector has taken up the role of being the largest source of new debt in the United States. This shift in debt issuance is readily apparent in Chart 1. Since the crisis of 2008, the growth in government debt has dramatically decreased from nearly 20 per cent annually to less than 5 per cent, more in line with the nominal growth in the economy. Consumers continue to remain wary of increasing their debt load . On the other hand, the corporate bond market has been on a bit of a tear in recent years .That segment of the debt market now outpaces all other debt issuers. The U.S. corporate bond market is valued at nearly US $9 trillion; by comparison, it is larger than the GDP of Germany, France and the U.K. combined. No longer are governments the leaders in generating new debt, it has ceded that title to corporate America.

Chart 1: Growth Rates in Debt of U.S. Non-financial Sector 2010-2015

As investors search for yield, corporate bonds are viewed as the darlings of the debt market, principally due to higher yields offered. As the demand for corporates grows, the spread in yields between corporates and U.S. Treasuries has narrowed, a further sign of the strength of the corporate bond market, thus encouraging more companies to issue debt. The rise in corporate debt is supplied mainly by investment-grade corporations i.e. from corporations with excellent credit ratings. High yielding debt (so-called junk bonds) is not as responsible for the burst in corporate debt as is often portrayed in the media . Well-heeled corporations have turned to corporate debt, rather than issuing additional equity, to meet their business needs.What lies behind the surge in new corporate debt?

Chart 2: U.S. Corporate Bonds--Annual Issuance and O/S Amounts ($mill)

Profits are inadequate to fund capital expenditures. Notwithstanding the fact that the stock market is reaching historic highs, corporate profits have steadily declined. The S&P 500 companies have experienced six straight quarters of declining profits. Table 1 connects profit growth with capital expenditures. To begin with, capital expenditures are, initially, funded from internal resources------- profits less dividends, less income taxes, plus accumulated capital cost allowances. From 2010 to 2013, U.S. non-financial corporations were able to fund business capital expenditures from internal resources. Since 2013 the sector has turned to the debt market to make up the shortfall, currently at approximately $200 billion. In and of itself, there is nothing inherently wrong with this approach, since it is vital to a company's long-term viability to increase and improve its capital investment. Raising debt to fund business investment, rather than raising equity, is an acceptable strategy to take, especially in this low interest rate environment.

Table 1:  US Non-financial Corporate Business, ( $ billions)

Pressure to Increase Dividends. Shareholders are pressuring corporations to increase dividends in the wake of falling yields on bonds. Now, investors are piling into dividend stocks to meet their long-term goals. Today, approximately 60 per cent of S&P companies generate a dividend yield--- the annual payout as a share of the market price---- that exceeds the yield on a 10 year Treasury bond. Historically, the relationship was just the opposite as investors looked to stocks to provide capital gains, not dividends, and to bonds to provide yields above the dividend rate.

Rising Operating Costs. Debt issuance has soared while cash from operations has weakened, suggesting that many firms have turned to the debt market to help cover operating expenses. Chart 3 measures the rise in corporate debt against cash flow for the S&P 500 companies. The steeply sloped ratio of debt-to-free cash flow strongly suggests that corporate debt is being used to support daily operations.

Chart 3:  Comparison of Debt Relative to Cash Flow 

Corporate Stock Buybacks are all the Rage. U.S. corporations have conducted many experiments involving financial engineering. In response to the pressures to increase shareholder value, hundreds of U.S. corporations conduct continuous programs to buy their own shares in the open market. In some cases it is done to offset stock dilution created by employee stock options; in other cases firms consider buybacks as the highest and best use of corporate cash; and, in other instances, the maintenance of high stock prices leads to granting greater bonuses to top management. Whatever the reasons, the rise in corporate buybacks is quite dramatic (Chart 4). The extent of these programs can be measured in terms of both the total amounts--- $1.6 trillion ---and the breadth of companies conducting such programs---nearly 400-- so far in 2016. Both measures rival that experienced prior to 2008 and every indication is that this trend will continue.

Chart 4: U.S. Corporate Repurchasing Shares, 2005-2016 (Q1)

No matter how low interest rates get, it is hard to justify the raising of corporate debt to purchase outstanding stock. Longer term debt should be used for longer term needs, e.g. capital expenditures. But from a macroeconomic view, raising stock price does not figure in promoting economic growth or general well-being--- it is simply financial engineering serving the interest of only shareholders and management. No new jobs are created and no new capital investment is undertaken in a world of corporate buybacks. Investors are simply bribed with their own money.

Chart 5: Use of Corporate Cash

The Carlyle Group summarizes the use of corporate cash in Chart 5. Since 2009, share buybacks have increased at enormous rate of 194% ; dividends have grown by 67%; and, business investment expanded a modest 43%. Rewarding shareholders with higher dividends and propping up share prices at the expense of investment in new plant, equipment and technology is a serious misallocation of resources at a time when the economy is experiencing slow growth and very poor productivity performance. It also represents serious short-sightedness on the part of management who feel so beholden to shareholders that they risk the longer term health of their companies.
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