What to Learn From the ECB’s Great European Corporate Bond Squeeze

The European corporate bond market heads into ever more extraordinary territory

By Richard Barley

The ECB headquarters in Frankfurt, Germany. Since the ECB’s announcement of corporate debt purchases in March, yields on euro-denominated nonfinancial bonds have dropped precipitately. Photo: Agence France-Presse/Getty Images

The grip that the European Central Bank is exerting on the continent’s corporate bond market through its purchase program is almost palpable. But it isn’t clear how much more it might be able to squeeze the market before somebody gets hurt.

Since the ECB’s announcement of corporate debt purchases in March, yields on euro-denominated nonfinancial bonds have dropped precipitately, to the lowest on record.

Investment-grade debt now yields just 0.52%, according to Bank of America Merrill Lynch index data, down from 1.28% before the policy was unveiled. While the total corporate purchases of €17.8 billion ($20.06 billion) so far are tiny next to the €980 billion of government bonds the ECB has bought, they have been bigger than many in the market expected.

But the relentless rally in corporate bonds has slowed in August. That may be simply down to sleepy summer conditions, with investors on the beach rather than at their desks, and markets more broadly becalmed. ECB purchases have slowed somewhat too. But it may also reflect the way that valuations are being pushed into stretched territory.

From one perspective, the spread between corporate and government bond yields still looks relatively wide. Take triple-B rated nonfinancial corporate debt—the lowest-rated debt that still qualifies as investment-grade—as an example. It offers a spread of 1.12 percentage points over governments, according to BAML’s index, nearly double the tightest spread on record of 0.58 point.

But that spread is flattered by underlying negative yields. A good chunk of the compensation on offer simply makes up for the fact that buying and holding a similar maturity German government bond is now a money-losing certainty.

On another measure, triple-B spreads look uncomfortably tight. Relative to single-A rated euro-denominated corporate bonds, they offer a pickup of just over 0.3 percentage point—less than half the average since 2000. The only time that this spread has been tighter on a sustained basis was between late 2006 and mid-2007, the height of the pre-crisis credit bubble. Back then, the rise of the credit-derivatives market and structured products pushed spreads tighter seemingly regardless of fundamentals. Now, the exogenous force is the long arm of the ECB.

The U.S. market, by comparison, is less distorted. The gap between single-A and triple-B yields there is 0.73 percentage point, well above the lows recorded pre-crisis, and much closer to the average since 2000 of 0.82 point.

Spreads could yet tighten and yields fall, although this would raise risks for investors further.

Negative yields on government bonds look absurd, but can be rationalized in part as an insurance fee in an uncertain world. But investment-grade corporate bonds bear obvious credit risk, which can materialize swiftly due to competitive shifts, mergers and acquisitions, or corporate wrongdoing. Investors should be paid for that risk.

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