Have central bank interventions revalued corporate loans? Part 2

The European Central Bank (ECB) began purchasing corporate bonds in 2016 as a part of its Corporate Sector Purchase Program (CSPP). Due to its clear and unequivocal legality, the CSPP could raise expectations amongst investors of an “ECB put” that the bank will “do whatever is necessary” to supply liquidity within the event of a crisis and restore order to financial markets. The program could subsequently have an enduring impact on European credit markets.

What does the info show? Has the CSPP revalued corporate loans in Europe?

Unlike the Fed, the ECB has limited its corporate bond purchases, shown within the chart below, to investment grade (IG) bonds. While the Fed bought $14 billion in bonds and exchange-traded funds (ETFs) in 2020, the ECB bought that much in the primary two and a half months of the COVID-19 pandemic alone. These purchases accounted for a much larger percentage of the European corporate bond market, which is lower than half the dimensions of its U.S. counterpart.

ECB corporate bond purchases: Significant and ongoing

But if the U.S. experience is anything to go by, investors’ perceptions are influenced not only by the dimensions of bond purchases, but in addition by how confident market participants are that the central bank will intervene in difficult times.

Options adjusted spreads

Historical option-adjusted spreads (OAS) for A- and BBB-rated European corporate bonds (see below) widened to all-time highs in the course of the global financial crisis (GFC) and widened again in the course of the European sovereign debt crisis in 2011. While the ECB launched aid programs to combat the worldwide financial crisis within the wake of the sovereign debt crisis and prolonged these to the banking sector, it only purchased assets directly in 2016.

Euro Corporate Option Adjusted Spreads (OAS)

Since then, the selloff has been the most important challenge for the Fed and ECB in 2020 and the primary instance where evidence of a central bank put could emerge. Like the Fed, the ECB increased its asset purchases in response, and credit spreads returned to their pre-COVID-19 crisis levels by the tip of 2020.

While crises triggered by different triggers don’t allow for a direct comparison, spreads have risen much less in the course of the pandemic than within the previous two sell-offs. Perhaps the ECB and other central banks have learned from past experiences and acted more quickly.

A have a look at the history of credit spreads before and after the ECB began asset purchases shows no conclusive evidence of an “ECB put”. However, it does suggest that the market has modified for the reason that ECB first intervened. Median credit spreads for A-rated bonds in Europe are consistent with pre-CSPP levels, in response to the figure above, while spreads for lower-rated BBB-rated debt have narrowed since 2016. Of course, in a low rate of interest environment like that of the previous few years, investors’ hunger for returns is growing. US credit spreads tell the identical story. When there may be an expectation that central banks will intervene in crises, greater risk-taking appears “safer.” However, the lower median spreads also got here against a backdrop of an enormous increase in corporate credit issuance and company debt.

The spread attributable to the pandemic is more muted than in previous crises

Annualized spread volatility, calculated from weekly spread changes, is shown within the chart below. Since the start of the CSPP, spread volatility has decreased. Although correlation shouldn’t be causation, lower spread volatility and lower equilibrium spread levels could indicate an implicit ECB put. Although the Fed also bought debt during this era, its purchases were limited to Treasury bonds and agency mortgage-backed securities (MBS) until the pandemic hit. While average spreads have declined within the United States, economic growth has been relatively robust as investors sought riskier assets. The significant increase in downgrades could explain why BBB spreads showed barely higher volatility as firms took advantage of lower yields to pad their balance sheets.

Are credit spreads behaving higher given the ECB purchases?

The consequence of this case is that a central bank put is more likely to mitigate the acute spread widening and result in lower volatility. The distribution of spreads would then have shorter tails or not less than shorter right tails. The following exhibit confirms this.

Thinner Tails on display, but the shortage of events gives cause for thought

Due to the inherent asymmetry of corporate debt, we expect the distribution of weekly spread changes before and after the implementation of the CSPP to have a wider right tail. Although there may be a fat tail, it shouldn’t be as pronounced in A-rated debt – even though it would definitely be the case in debt below IG and other markets with higher default risk. The distribution for BBB-rated corporate bonds has an analogous shape and the tails are shorter because of lower spread volatility.

Here too, the period after the CSPP is simply six years and there have been fewer extreme events than within the 18 years before. Still, the marginally tighter spreads, lower spread volatility and shorter right tail could point to a central bank put.

Realized spread behavior vs. fair value model

We also searched for evidence of an ECB put by comparing realized spread behavior with several corporate spread fair value models published by major investment banks. These models are based on monthly fair value estimates of broad market ranges and apply quite a few reasonable aspects to estimate the value of credit risk. The UBS model we deal with here uses explanatory variables that capture economic fundamentals, credit performance and market liquidity metrics to estimate the suitable level of spreads. Modeled spreads have historically replicated actual spread behavior, as shown within the figure below.

Spreads will widen lower than expected in 2020

The March 2020 pandemic sell-off is the primary extreme market event for the reason that introduction of the CSPP, and in response to the model, European IG bond spreads must have increased by 265 basis points (bps), from 94 bps in early February to almost 360 bps. However, they only expanded by 135 basis points, or about half that quantity. The spreads for high-yield bonds that the ECB doesn’t buy also didn’t rise as much as predicted within the model.

Of course, these generalized models cannot account for all market-moving aspects and deviations can occur for countless reasons. For example, the figure above shows that European IG spreads have recently increased greater than forecast. Why? Due to weak economic performance in Europe, an abrupt withdrawal of quantitative easing (QE) by the ECB and lower than expected liquidity.

However, the undeniable fact that the spread widened greater than expected because the ECB scaled back its stimulus measures, stopped buying recent debt and stopped expanding its balance sheet doesn’t negate the existence of an ECB put. The ECB, just like the Fed, has prioritized fighting inflation and appears willing to simply accept slower growth, not less than for now. What the ECB would do if the economy went right into a tailspin or financial markets took a nosedive is an open query.

Options markets

Do the choices markets provide insight right into a possible central bank put? If investors expect lower volatility and losses during times of stress in the longer term, might they pay less for loss protection?

The following figure compares the implied spread expansion of the iTraxx Main 3m 25d payer swaptions in basis points per day with the actual credit spreads of the iTraxx Main index once they grew by greater than 50 basis points. Protection costs rose in step with the severity and duration of spread widening. In late 2015/early 2016 and again in 2020, protection costs didn’t appear to extend as much as in previous crises or within the empirical models described above. In late 2015/early 2016, spreads increased more slowly, there was no sudden market shock and the rise in volatility was less severe. In 2020, spreads rose significantly more, began to recuperate more quickly, and the associated fee of hedging against losses fell rapidly.

Even in the present market downturn, which was initially attributable to rising rates of interest, spread expansion was slightly muted. Although fears of a recession have increased recently and the war between Russia and Ukraine actually has the potential for surprises, spreads haven’t widened all that much.

Increase in insurance costs more subdued

So has there been a central bank placed on the bond markets? While there are few extreme sell-offs against which to check the hypothesis, the limited evidence from Europe suggests that it is feasible. And since there are not any legal or legislative hurdles to further intervention by the ECB bond markets, investors could possibly be forgiven for anticipating such a put.

But the situation within the United States is different. The Fed’s corporate debt buyback program is newer and there are barriers to further intervention. Nevertheless, the Fed has opened the door. In the ultimate a part of this series, we’ll examine whether this has modified the US bond markets.

Don’t miss the primary article on this series.

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