By Andrew Wilson
All eyes last week were again on the European Central Bank, which released further details on its quantitative easing (QE) policy. QE is designed to be a shot in the arm for the eurozone economy, stimulating lending by pulling rates lower and boosting exports through currency depreciation, but few major central bank interventions come without unintended consequences. Policy is set to achieve headline macroeconomic goals, which often act against the interests of individual markets.
This is especially true in the current environment, as today’s generation of central bankers continue to grapple with the financial crisis – trying to find a path to meaningful economic expansion in Europe, while in the US the Fed is taking the first steps towards normalising interest rates.
In Europe, rates were already set at zero in a bid to promote growth, with an inevitable effect on the pricing of new bonds, but since January’s announcement of QE yields have been suppressed even more: investors now have to go out to seven years to obtain positive yields on bunds.
Some remarkable yield differentials are now visible as a result: at the time of writing, investors were being paid 1.6% to invest in five-year US Treasuries but only 0.8% to do so in Portuguese government bonds of the same maturity, with investors in Portugal receiving less compensation for their risk along the length of the yield curve.
Extreme though the effects are, this is of course consistent with the goals of QE, which is designed to suppress yields in what should be low-risk instruments such as government bonds, thereby encouraging investment further along the credit curve, specifically in corporate borrowers, from both buy-side institutions and lending banks.
Last week the ECB president Mario Draghi, buoyed by an upward revision to its growth and inflation forecasts, sought to mitigate some of QE’s effect on fixed income markets – notably by announcing that the ECB will not buy bonds yielding less than its own deposit rate – but even so a sustained repricing is likely.
This is inevitably a headache for long-term institutional investors, which require dependable cashflows from their positions to meet their obligations. If yields in the securities they previously favoured are now no longer acceptable, they have to find others.
But thanks to the highly divergent policies now being adopted by the European Central Bank in the eurozone and the Fed in the US, there is growing variety available to European investors as they search for replacement assets.
Pricing a bond is, like so much in finance, an art rather than a science: issuers and their advisers have to consider their own existing bonds, recent pricing by comparable borrowers and the relevant government benchmark. While there have been some notable exceptions, typically a corporate issuer pays more to borrow from the bond market than a government. Given the difference in yields between European government benchmarks and US Treasuries, American issuers are therefore currently incentivised to take new bond issues to the European market rather than their domestic investor base, which understandably demands a premium to Treasury issues.
There are of course additional expenses associated with issuing in this way, notably the cost of swapping the funds raised in euros back to dollars, but even after hedging we estimate that savings of 20 to 30 basis points are on offer.
The popularity of the European marketplace among US issuers is clear: according to Dealogic, issuance from American corporates amounted to $40bn in 2014, with volumes running to more than $16bn so far in 2015.
Investing in them often entails some work for European funds – there may not be local research coverage of such issuers and they may have to put new credit lines in place – but with game-changing developments such as QE changing the yield environment for investors, the effort required could be well worth it.
This does not necessarily serve the interests of the ECB: QE was not intended to drive European capital to US borrowers. But however necessary its intervention in pursuit of macro goals, investment institutions still have a mandate to achieve the returns they promise their own investors.
Andrew Wilson is CEO of Goldman Sachs Asset Management.
Comments