Despite growing concerns that central banks are reaching the limits of their powers, the ECB’s actions on 10 March indicated further scope to run. In addition to interest rate cuts, the ECB announced two initiatives focused on kick-starting growth: 1) a new series of targeted longer-term refinancing operations (TLTRO II) for banks and 2) an expansion of its bond buying program to €80 billion a month, including extending eligible securities to euro-denominated investment grade corporate bonds.
The end goal of these initiatives is clear – to encourage more lending to businesses and households. But how do we expect investors to react, and what is the likely impact on credit markets?
Turning first to the TLTRO II, this is a measure designed to aid a banking system facing negative interest rates and market volatility. As in previous programs, this should be very supportive for European banks, and specifically bank credit, as it helps anchor the cost of funding – and this is essential in normalizing valuations across a capital structure that has seen significant dislocation in recent months.
However, we believe the ECB’s decisions are less supportive for bank equities, which typically need volume and margin growth to perform. And while the TLTRO II will help offset some of the impact of the deposit rate cut, we are still living in a negative rate world. For this reason, we continue to favor investing in bank credit over equity, particularly Additional Tier 1 (AT1) bonds issued by the strongest European banks, which offer attractive valuations and risk-adjusted return potential.
The ECB’s second key announcement – the expansion of its bond-buying program to include corporates – will also be supportive for credit, particularly higher-yielding sectors.
The purchase of euro-denominated investment grade non-subordinated corporate bonds issued by non-bank European-based companies is a new addition to the ECB toolkit. We estimate that the universe of eligible bonds is about €500 billion and that the ECB could purchase up to €5 billion per month, or 1% of the total. Exacerbated by the reduced liquidity and the lack of inventory on dealers’ balance sheets, the ECB purchases are likely to significantly compress credit spreads and lower volatility. This could push investors further along the risk spectrum into longer-maturity, lower-quality assets and outside the low-yielding eurozone.
In the long term, absolute returns in European investment grade credit may be limited by the ECB’s actions. However, in the shorter term, spread compression should be positive. Furthermore, investors may benefit by moving into higher-yielding assets, such as European high yield, bank capital and U.S. corporates.
The key investment takeaway is not to fight the ECB as it turns to credit: European investment grade spreads should compress, but higher-yielding sectors of the market can continue to be attractive alternatives to equities and lower-yielding bonds.