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PEPP Talk

While the short-term benefits of the pandemic emergency purchase programme (PEPP) are obvious, we question its longer-term implications.

 

Since then-president Mario Draghi’s ‘whatever it takes’ moment in 2012, there have been multiple ways in which the European Central Bank (ECB) has intervened in European capital markets, both indirectly through the banking sector with longer-term refinancing operations, and directly through capital-market activities.

CSPP – intervention with a big impact

After limiting quantitative easing initially to asset-backed securities and government bonds, the ECB took the surprise step in 2016 of starting direct buying of investment-grade corporate bonds through its Corporate Sector Purchase Programme (CSPP).

The impact of the CSPP can hardly be underestimated, as the chart below illustrates.

After announcing the end of the CSPP during the second half of 2018, triggering a subsequent selloff in risk markets, the ECB started to reinvest the principal payments from the maturing securities held in the CSPP portfolio, with the programme itself being revived less than a year later in the second half of 2019.

Enter the PEPP

Fast forward to March 2020 and the impact of COVID-19. The ECB’s Asset Purchase Programme (APP), of which the CSPP is a part, was bolstered further by the pandemic emergency purchase programme (PEPP) to provide additional stimulus. Currently standing at €750 billion, the fund can expand to €1.85 trillion until the end of June 2021.  

To put these programmes into context, since April 2020 the ECB has purchased circa €70 billion of corporate bonds under the CSPP and PEPP, compared with circa €290 billion of euro corporate primary issuance (excluding banks and insurance).

ECB could own almost 40% of the eligible universe by the end of 2021

The ECB remains the biggest player in the euro corporate credit markets, with €271 billion of holdings (€250 billion under CSPP and €21 billion under PEPP). We estimate the ECB’s holdings to equate to circa 25% of the current €1.1 trillion eligible universe once we account for the ECB’s eligibility conditions (the main ones being euro-area domiciled, as well as the exclusion of all subordinated bonds and bank debt).

Assuming the CSPP and PEPP continue last year’s pace of buying, together with our limited net non-financial euro corporate supply expectations, we believe the ECB could end up owning nearly 40% of the eligible universe by the end of 2021.

The long-term impact is highly questionable

ECB corporate bond purchases benefit companies in the short term through lower funding costs. By providing a ‘backstop bid’ for traders they also allow for an improved credit flow and liquidity, thereby creating a positive backdrop for issuance in European credit markets.

The flipside of these purchases is the compression in yields that especially benefits the lower end of the credit spectrum, supporting companies that otherwise might have been forced by the market to deleverage or restructure. Misallocation of capital is even more a risk if it relates to sectors that are under pressure due to long-term secular trends or technological change.

Negative-yielding debt

A final consequence of the ECB involvement is that it leads to an increasingly negative-yielding market. We estimate that 60% of the bonds held by the ECB currently have negative yields, and over 40% of the euro investment-grade credit market is trading on a negative yield as well. Further ECB buying of corporate debt would ultimately force out strategic investors and encourage high and potentially excessive leverage.

We do not expect a sudden withdrawal of the stimulus, as it would be likely to lead to a market shock. Furthermore, gradually retracting the support is also likely to be hard, considering the ECB needed to restart the CSPP less than a year after stopping it back in 2018.

For the time being, and against our better instincts, it looks as if we need to prepare ourselves for more PEPP.

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