The ECB’s corporate sector purchase program has given investment grade corporate bonds a huge boost. Moreover, growth in ‘corporate hybrids’ and ‘reverse Yankees’ offers attractive yield pick-up opportunities.
The European Central Bank’s corporate sector purchase program (CSPP) has created an attractive environment for investment grade corporate bonds. Since June 2016, the central bank has been buying ‘non-bank’ corporate bonds of euro area issuers. As a result, non-financial corporates have delivered an impressive total return this year (+7.1% through August), clearly outperforming the financial sector.
The ECB has stated that the CSPP will run at least until the end of March 2017. This program will therefore continue to enhance returns and reduce volatility for non-financials. In addition, the European investment grade corporate market has enjoyed two positive developments in recent years. Growth in ‘corporate hybrids’ and ‘reverse Yankees’ provides attractive opportunities to deal with the low yield environment. As they fall outside the universe of the ECB’s corporate purchasing program, these two types of bonds provide a higher yield.
The start of this year was marked by significant volatility in credit markets due to falling commodity prices and Chinese growth fears. The ECB announced in March that it would include non-bank credits as part of its purchase program and began buying in June. This was the trigger for a strong rally in the non-financial corporate sectors like industrials and utilities. The surprise ‘Brexit’ vote did have a negative impact on the credit market in June, but as can be seen from the graph below this weakness was short-lived. Spreads and yields tend to revert back as they are driven by investors searching for yield, with the added impact of the ECB’s corporate purchasing program fueling demand.
The ECB is an important factor in the market, buying around EUR 300-400 million of corporate bonds every working day. This implies a run rate of up to EUR 8 billion per month, much more than most participants had expected. People were skeptical that it would have any effect, but as the ECB can buy across the whole non-bank corporate market it has been able to reach these game-changing volumes. Looking at the current stance of the ECB on growth and inflation in the euro area, they could extend the corporate bond-buying program beyond March 2017.
The ECB can buy corporate bonds that have at least one investment grade (IG) rating (BBB-) from one of the world’s leading rating agencies. This means split-rated (BBB-/BB+) bonds are also in scope, as long as there is one IG rating. There are no restrictions on maturities. All in all, the total pool the ECB can access is some EUR 600-700 billion. This is larger than expected, which explains the strong momentum in the market.
Aside from the ECB’s activity, the market offers two additional opportunities: corporate hybrids and reverse Yankees. These sectors are outside the ECB’s eligible universe, so demand for them comes purely from investors like asset managers and insurance companies. As they do not benefit from the extra demand generated by the central bank, they do not trade at the same, relatively expensive level.
Corporate hybrids are bonds that have some equity-like features. They are subordinated to all other forms of debt, and are often perpetual, i.e. without a final maturity but with a call structure instead. The coupon can be deferred, but must be paid once the company pays a dividend on its shares. As a result, rating agencies treat these corporate hybrids partly as equity. For non-financial corporates it is a tool to strengthen their balance sheets, similar to Tier-1 and Tier-2 debt in the financial sector. And corporate bond investors like the higher yield on these instruments.
The hybrid sector has grown rapidly in recent years, and with various new issuers from different sectors diversification has improved as well. It used to be very much driven by telecommunications companies and utilities, but now we’re seeing more cyclical names issuing these hybrid bonds.
A new development in the euro investment grade market has been the increase in issuance by US corporates, known as reverse Yankee bonds. US companies have increasingly used Eurobonds since last year, attracted by the low cost of funding. Corporates like AT&T or Verizon already knew how to tap the euro market, but now many new and unknown issuers have come to the euro market as well.
Reverse Yankees also offer higher spreads as they issue for the first time and the ECB is not allowed to buy US based issuers. This leads to interesting valuation differences. When a BBB-rated US utility first came to the euro market this year it was paying a spread of 140 basis points. A comparable Italian utility bond had a spread of only 70 basis points at that time. This was an opportunity to increase yield and improve diversification.
We see more upside in terms of the potential for spreads to continue to tighten for both hybrid and reverse Yankee bonds. Investors continue to search for yield and they can find it in these two growing sectors.
The decision of the ECB to add corporate bonds to its menu provides a positive environment for non- financial corporates. Returns are enhanced while volatility is being reduced, as the ECB buys impressive amounts of corporate bonds on a daily basis. In addition, there are new opportunities in two growing sectors with higher yields: corporate hybrids and reverse Yankees.