ECB Faces Struggle in Sourcing Enough Bonds for QE

Scant supply of top-rated government bonds poses challenge for asset-purchase program, say analysts

By Christopher Whittall

Updated Feb. 25, 2015 10:06 a.m. ET

 The European Central Bank’s headquarters in Frankfurt. The ECB plans to buy €60 billion of debt securities each month until September 2016, but some analysts and investors say it may struggle to find them. Photo: European Pressphoto Agency

The European Central Bank has pledged to buy hundreds of billions of euros of government bonds to help revive the eurozone economy. Now it will have to find them.

Analysts and investors are skeptical on its chances, though, given that many investors will be unwilling or unable to sell top-rated government bonds, particularly those belonging to Germany.

“It will be challenging for the ECB to source enough government bonds to meet its QE targets,” said Anthony O’Brien, co-head of European rates strategy at Morgan Stanley.

From next month, the ECB’s program of quantitative easing, or QE, involves buying €60 billion $68 billion) of debt securities each month until September 2016. Since late last year, the central bank has been buying around €13 billion of other assets a month, and analysts expect the difference—around €47 billion—to consist of government bonds.

Which government bonds the ECB buys depends on each country’s share of the European Union’s population and gross domestic product.

The problem is top-rated bonds are already in short supply—especially Germany’s, which make up the largest individual chunk of the program. German government debt, or bunds, will account for just over a quarter of the purchases, or around €12 billion each month.

But the German treasury says it expects to issue this year €147 billion of eligible bonds—those with maturities of two to 30 years—while €132 billion of bonds will mature, meaning net new bund issuance of just €15 billion for the whole year. Overall, the ECB’s plans mean it has to buy €215 billion of German government bonds between this March and September 2016—26 times more than the amount the German government bond market is predicted to grow over the same period, Morgan Stanley says.

This contrasts with the Federal Reserve’s multitrillion-dollar QE program, which was done against a backdrop of plentiful bond supply from the U.S. Treasury.

Peter Praet, the ECB’s chief economist, said the bank should be able to find enough investors willing to sell government bonds.

“We hear that pension funds and insurers don’t want to sell…But banks will probably rise to the bait,” Mr. Praet told Belgian weekly Trends in an interview released Wednesday.

“Institutions outside the eurozone also have large holdings of government bonds. They can sell too.”

The ECB could find that buying in-demand bunds from investors on the secondary market won’t be easy either. Investors have already sent yields on bunds tumbling. The yield on 10-year German government bonds is now 0.34%, compared with 1.69% a year ago. Yields fall as prices rise.

ECB President Mario Draghi has said the ECB would consider buying negative-yielding debt.

“There is already a huge shortage of German bonds in the market,” said Philipp de Cassan, head of euro core rates trading at Nomura. “We’re already seeing the symptoms of an ECB buying program.”

Central banks and financial institutions own by far the majority—around 90%—of the €1.1 trillion German government debt market. Banks and insurance companies favor these bonds because they help them meet regulatory capital requirements, while central banks also tend to hold bunds and other top-rated government bonds when building their foreign-exchange reserves.

“[European] passive investors and banks are unlikely to sell bunds in large size due to investment mandates and regulatory reasons,” said Cagdas Aksu, rates strategist at Barclays .
Anke Richter, head of European credit research at Conning, a U.S.-based asset manager with around $90 billion in assets, notes that some client portfolios will have guidelines dictating that government bonds must account for a certain proportion of their investments.

“The logical assumption is that everybody is going to sell and move into something else, but not everybody can do that,” she said.

Other investors may be reluctant to sell top-rated government bonds because there is a lack of appealing alternatives. Around a quarter of euro-area government debt now has negative yields, according to J.P. Morgan , meaning investors effectively pay to hold these assets.

Swapping bonds with positive coupons for investments with negative yields “doesn’t look like a very sensible move” for many investors, said Frances Hudson, global thematic strategist at Standard Life Investments, which handles £195 billion ($301 billion) in assets.

The ECB’s governing council has said it may have to be flexible when choosing what bonds to buy. It has also pledged to lend out the bonds it purchases to help the market function more smoothly.

Mr. O’Brien said the ECB could loosen a self-imposed restriction not to own more than 25% of any single bond, aimed at ensuring the central bank doesn’t hold a stake large enough to block a debt restructuring. It could also consider increasing purchases of bonds belonging to government agencies, such as German development bank KfW, instead of government debt.

Analysts note that the ECB will find it easier to buy other government bonds such as those belonging to Spain and Italy, which should make up 17% and 13% of the program, respectively.

Meanwhile, some investors say the ECB will find willing sellers at the right price.

“There is definitely a scarcity of safe assets, but a price will be found,” said Luke Bartholomew, an investment manager at Aberdeen Asset Management , which oversees £323 billion in funds.

Further demand for 10-year German government bonds will push yields even lower, Mr. Bartholomew said, which is exactly what the ECB wants to achieve to get more cash flowing around the system.

“I see no reason why Germany’s 10-year bond yield can’t be negative by the end of the year,” he said.

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