‘Living In A Very Strange World’

In the immediate aftermath of the July ECB statement (which contained new language confirming that the technicalities around a new easing package are currently being discussed), yields pushed lower, in a repeat of the knee-jerk bond rallies that played out around weak eurozone PMIs on Wednesday and a disconcerting Ifo survey that hit just hours ahead of Mario Draghi’s press conference.

Among other things, 10-year yields in Greece hit new lows below 2%, trading inside of US Treasurys. German bund yields pushed below the ECB depo rate and benchmark Italian yields fell to the lowest since October 2016. That same morning, 10-year yields in the Netherlands, Finland, Austria, France and Belgium all dropped to new record lows.

Things would turn around as Draghi spoke, but the immediate reaction to the confirmation of more stimulus (which is what the July statement amounted to) was predictable, and telling. The green box below shows that knee-jerk (the red box is the reversal during Draghi’s press conference).

This comes on the seventh anniversary of Draghi’s legendary “Whatever it takes” moment (July 26, 2012) and as BofA’s Barnaby Martin notes in his latest European credit strategy piece, 10-year yields are now below their respective central bank rates in multiple locales.

(BofA)

Of course, the result of another plunge back down the accommodation rabbit hole (this time to new depths) will be yet another mad scramble down the quality ladder and out the risk curve, as investors scour the world for yield. That will leave everything priced to perfection – and then some.

The global stock of negative-yielding debt now sits at roughly $14 trillion, and as Martin reminds you, the real story is in corporate debt.

“Today there is €825 billion of negative corporate debt, and some sectors have almost half of their bonds yielding below zero”, he marvels, on the way to predicting that with demand still strong thanks to the perception that corporate bonds are “perceived as a better ‘store of cash’ than parking money with custodians”, it’s likely that “negative credit could soon be the norm”.

The list of statistics and factoids one can draw from when painting the € high grade market with the Salvador Dalí brush is virtually endless. That €825 billion figure Martin cites is larger than Switzerland’s economy. All told, some 40% of the € high grade credit market is now negative yielding. In some sectors (e.g., tech, healthcare and consumer), the majority of bonds will soon be negative-yielding.

(BofA)

This state of affairs continues to raise one simple question among casual market observers. Namely: Who is buying this? To that, Martin offers the following explainer:

The obvious question becomes “who is buying negative yielding credit?” given the risks inherent in corporate debt – be it event risk, shareholder-friendly activity or the risk of plunging bonds. Yet, we see very robust demand for negative yielding € credit across the marketplace. Why? Because they serve as “attractive” avenues for fund managers to park excess cash. Anecdotally, we hear from some clients that their custodian charges for cash holdings are as punitive as -60bp. In this regard, negative yielding corporate bonds can still be viewed as “cheap”. Or, put another way, negative yielding credit is turning into a classic Giffen good.

If you’re wondering whether that opens the door to corporate bond yields pushing even further into negative territory in Europe, the answer is obviously yes. If you’re looking to park cash and you’re effectively getting taxed to do it, you’re going to stash it wherever that tax is the least punitive, in the process pushing yields on those assets lower still.

For Martin, that straightforward reasoning means that “front-end corporate bonds can still be pushed even tighter…perhaps even to the unthinkable yield of -60bp”.

(BofA)

In addition to the obvious factors driving this phenomenon, BofA goes on to explain that corporates are doing the opposite of sovereigns by lowering the average maturity of their debt (as opposed to terming it out). That’s somewhat counterintuitive (i.e., why would corporates not want to lock in financing while long-term borrowing costs are low?), but Martin walks through a trio of market dynamics that explain it.

Ultimately, the result is that corporate credit isn’t as susceptible to the interest rate risk inherent in the higher duration sovereign market.

In a testament to how self-referential all of this really is, Martin then notes that because corporates are shortening the average maturity of their debt profiles, the ECB “has to remain dovish for longer, and assure bond market conditions are smooth enough for continuous refinancing activity”.

And so, the whole thing is perpetuated, as a collection of self-referential dynamics overlap and feed into one another like a giant, moving Venn diagram.

As Martin puts it, we’re all going to have to try and “learn to live in a very strange world”.