Taking it to 11
How central banks are distorting the corporate-bond and equity markets
IN THE spoof “rockumentary”, “This is Spinal Tap”, Nigel Tufnel, the band’s guitarist, displays his amplifiers with pride. The dials range not from one to ten, but up to 11. On a normal amp, he explains, when you reach ten, there is nowhere to go, but “these go to 11.”
Three of the world’s most important central banks—the Bank of England, Bank of Japan (BoJ) and the European Central Bank (ECB)—have dialled monetary policy up to 11, expanding their asset purchases from government bonds to embrace corporate debt and even equities.
With government bonds and short-term interest rates already at historically low (and in some instances, negative) levels, such asset purchases were seen as the next logical step.
The expanded policy has several justifications. It is not clear that driving government-bond yields or short-term interest rates any lower will do a lot to help the economy; negative rates may dent bank profits, for example, making them more reluctant to lend. And if the aim is to get companies to borrow more, then buying their bonds will reduce the cost of that borrowing via lower yields.
But there are many more types of private-sector assets than there are government bonds. (The ECB’s government bond-purchase programme is linked to the size of each euro-zone economy, so it cannot be accused of favouring one nation over another.) Central banks simply cannot buy all corporate bonds or equities in equal measure.
Naturally, they choose the most liquid and the least risky. But the bonds and equities they buy are likely to perform better than others. Since the ECB announced its bond-buying programme on March 10th, the spread (or excess interest rate over government bonds) on corporate bonds that it deems eligible has fallen by over half, from 100 basis points (one-hundredths of a percentage point) to 44 basis points, reckons Citigroup. The spread on ineligible bonds has also fallen but by only a third, from 154 to 104 basis points.
When companies seek to issue new bonds, the prices and yields of their existing bonds are an important benchmark. To the extent that central-bank actions lower the cost of capital of businesses within the programme, it must give them a competitive advantage over their rivals.
The Bank of England, for example, is buying bonds issued by Walmart (which owns the Asda chain in Britain) but not bonds issued by Tesco or Morrisons, two rival supermarkets. The effect may be small, but it is still a questionable thing for a central bank to do.
Moreover, the British corporate-bond market is not as deep as the American equivalent so the Bank of England is limited in the bonds it can buy. This leads to some odd-looking inclusions. Will the purchase of sterling bonds issued by Apple, Daimler or PepsiCo really lower the cost of capital for British finance?
Investors will adjust their behaviour to allow for the actions of central banks. “It almost feels as if our role shifts from analysing the bonds’ fundamentals to advising clients on the eligibility criteria,” says Matt King, a bond strategist at Citigroup.
The BoJ has already been forced to adjust its equity-buying programme after it seemed to distort the market. The bank might have thought it was playing safe by purchasing an equity index. But a lot of its money was going into the Nikkei-225 average, a benchmark weighted by share price rather than market value (see chart). So its investments were having a disproportionate effect on the share prices of some small companies. In the case of Fast Retailing, the BoJ already owns half of the free float (the shares available to outside investors).
Future purchases will be weighted to the more sensibly constructed Topix index.
Another issue is how the central banks will eventually dispose of their holdings. Although, when they started in 2009, government-bond purchase schemes were seen as short-term measures, central banks have yet to reduce their bond piles. The Federal Reserve is slowly tightening monetary policy by pushing up short-term interest rates, not by selling bonds.
Corporate bonds are less liquid than government bonds, particularly since post-crisis rules have made banks less willing to hold inventories. A likely consequence of this is that central banks will be big owners of private-sector assets for a while, with all the distortions that implies. They will not want to risk a big shock by selling billions of bonds into an illiquid market. If that day comes, traders might be quoting Mr Tufnel again: “How much more black could this be? And the answer is none. None more black.”