The first article in this series was published in November 2022.
The European Central Bank (ECB) began purchasing corporate bonds in 2016 as part of its Corporate Sector Purchase Program (CSPP). Given its clear and obvious legality, the CSPP could create expectations among investors for an ‘ECB put’. In the event of a crisis, it will do “whatever it takes” to provide liquidity and restore order to financial markets. The program could therefore have a lasting impact on the European credit market.
So what does the data show? Has CSPP reassessed European corporate credits?
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Unlike the Fed, the ECB limits corporate bond purchases to investment grade (IG) bonds. The Fed said he bought $14 billion in bonds and exchange-traded funds (ETFs) in 2020, while the ECB bought the same amount in just his first two-and-a-half months of the COVID-19 pandemic. bottom. These purchases represent a much higher proportion of the European corporate bond market, less than half the size of US corporate bonds.
ECB bond purchases: a significant and ongoing purchase
![Chart showing the size and persistence of ECB bond purchases](https://i1.wp.com/blogs.cfainstitute.org/investor/files/2023/01/ECB-Corporate-Bond-Purchases-Significant-and-Persistent.png?resize=640%2C263)
Source: Bloomberg
But if the US experience is any guide, investor perceptions are influenced not only by the size of bond purchases, but also by market participants’ confidence that central banks will intervene in difficult times.
option adjusted spread
Historical option-adjusted spreads (OAS) on European A- and BBB-rated corporate bonds, visualized below, widened to record highs during the Global Financial Crisis (GFC), with European sovereign debt in 2011 It expanded again during the crisis.The ECB launched a support program to counter the GFC and expanded into the banking sector amid the sovereign debt crisis, but did not directly purchase assets until 2016.
Euro Corporate Option Adjusted Spread (OAS)
![Chart showing Euro Corporate Option Adjusted Spreads (OAS)](https://i1.wp.com/blogs.cfainstitute.org/investor/files/2023/01/euo-corporate-oas.png?resize=640%2C249)
Source: ICE data
Since then, the 2020 plunge has been the most important challenge for the Fed and ECB, and the first instance where evidence of a central bank put may surface. Like the Fed, the ECB responded by ramping up asset purchases and credit spreads returned to his pre-COVID-19 levels by the end of 2020.
While crises triggered by different catalysts cannot be compared like-for-like, the increase in spreads during the pandemic was much smaller than during the two previous plunges. Perhaps the ECB and other central banks have learned from past experience and acted faster.
Looking at the history of credit spreads before and after the ECB started asset purchases does not show conclusive evidence of an ‘ECB put’. However, it suggests that the market has changed since the ECB first intervened. According to the previous chart, the median credit spread on his A-rated bonds in Europe is the same as it was before the CSPP, while spreads on his lower-rated BBB bonds have narrowed since 2016. . Over the last few years, investors’ hunger for yield has increased. US credit spreads tell the same story. Greater risk-taking looks “safer” when central banks are expected to intervene in times of crisis. However, median spreads have also fallen amid a significant increase in corporate credit issuance and corporate leverage.
Pandemic spread is more contained than past crises
![Charts show pandemics are holding back more infections than past crises](https://i0.wp.com/blogs.cfainstitute.org/investor/files/2023/01/Pandemic-Induced-Spread-Widening-More-Muted-Than-Past-Crises.png?resize=450%2C189)
2. May 4, 2011 – November 29, 2011
3. February 21, 2020 – April 3, 2020
Source: ICE data
Annual spread volatility calculated from weekly changes in spreads is displayed in the following chart. Since the CSPP launch, spread volatility has decreased. Correlation is not causation, but spread volatility and low levels of equilibrium spreads could be signals for his implicit ECB put. The Fed also bought Treasuries during this time, but until the pandemic hit, its purchases were limited to Treasuries and agency mortgage-backed securities (MBS). Although median spreads fell in the US, economic growth was relatively strong as investors pursued riskier assets. A large increase in rating downgrades could explain why BBB spreads showed slightly higher volatility as companies used lower yields to strengthen their balance sheets.
Do credit spreads work better in the presence of ECB buying?
![A chart to see if credit spreads behave better in the presence of ECB buying?](https://i2.wp.com/blogs.cfainstitute.org/investor/files/2023/01/Credit-Spreads-Better-Behaved-in-the-Presence-of-ECB-Buying-1.png?resize=640%2C153)
Source: : ICE Data and MacKay Shields
A corollary to this situation is that central bank puts are expected to moderate extreme spread widening, leading to lower volatility. The spread distribution has a shorter tail, or at least a shorter right tail. The following exhibition bears this out.
Thinner tails on display, but lack of events gives pause
![Chart showing Thinner Tails but lack of events pausing corporate credit spreads](https://i0.wp.com/blogs.cfainstitute.org/investor/files/2023/01/thinner-tails-exhibited-but-dearth-of-events-gives-pause.png?resize=640%2C247)
2. January 2016 – December 2021
Source: ICE Data and MacKay Shields
Due to the inherent asymmetry of corporate bonds, the distribution of weekly spread changes before and after the CSPP launch is expected to have a thicker right tail. There is a fat tail, but it is less pronounced in A rated bonds, but certainly in sub-IG bonds and other markets with high default risk. The BBB rated corporate bond distribution has a similar shape, with a shorter tail due to lower spread volatility.
Again, the period after CSPP is only 6 years, with fewer extreme events than 18 years ago. Nonetheless, somewhat tight spreads, low spread volatility and short right tails may indicate central bank puts.
Realized Spread Behavior and Fair Value Model
We also looked for evidence of an ECB put by comparing several fair value models of corporate spreads published by major investment banks to the movement of realized spreads. These models are based on monthly fair value estimates of broad market spreads and apply a set of rational factors to price credit risk. The UBS model featured here uses explanatory variables that capture economic fundamentals, credit performance, and market liquidity indicators to estimate fair levels of spreads. Modeled spreads have historically tracked the behavior of actual spreads, as shown in the following figure.
2020 Spread Wider Than Expected
![Chart showing spreads widening below expectations in 2020](https://i0.wp.com/blogs.cfainstitute.org/investor/files/2023/01/spreads-widen-by-less-than-expected-in-2020-1.png?resize=640%2C253)
The March 2020 pandemic-induced plunge was the first extreme market event since the start of the CSPP, with spreads on European IG debt slipping 265 basis points from 94 bps in early February to almost 360 bps, according to models. Points (bps) should have expanded. bps. But they only stretched by 135 bps, about half that. Spreads on high-yield bonds, which the ECB doesn’t buy, also didn’t rise as much as the model predicted.
Of course, these generalized models cannot incorporate all market-moving factors and deviations can occur for myriad reasons. , indicating that it has expanded beyond our expectations. why? Weak economic performance in Europe, a sudden pullback in quantitative easing (QE) from the ECB, and lower-than-expected liquidity.
However, the wider-than-expected widening in spreads as the ECB has scaled back its stimulus package, stopped buying new debt, and stopped expanding its balance sheet does not rule out the existence of ECB puts. The ECB, like the Fed, has prioritized fighting inflation and appears ready to accept slowing growth, at least for the time being. What he said the ECB would do if the economy stalled or financial markets plummeted is an open question.
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options market
Are options markets shedding any light on potential central bank puts? Can I pay less for
The chart below compares the implied spread widening (bps/day) of the iTraxx Main 3m 25d Payer swaption and the actual credit spreads when the iTraxx Main index increases by 50 bps or more. Protection costs skyrocketed in line with the severity and duration of widening spreads. In late 2015, early 2016, and even into 2020, the cost of protection did not appear to rise as much as in past crises or the empirical model above. Spreads rose more slowly in late 2015 and early 2016, there were no sudden market shocks, and volatility spikes were less severe. In 2020, spreads widened significantly, started to recover faster, and the cost of downside protection fell sharply.
Even in the current market downturn, initially caused by rising interest rates, the increase in spreads has been more muted. With recession fears mounting lately, a war between Russia and Ukraine certainly has the potential to be a surprise, but spreads haven’t widened much.
Premium increase More modest
![Graph showing rising insurance premiums](https://i1.wp.com/blogs.cfainstitute.org/investor/files/2023/01/Rise-in-cost-of-insurance-more-muted.png?resize=640%2C245)
Shaded areas indicate spread widening.
Source: Bloomberg, Goldman Sachs, Mackay Shields
So central bank puts have appeared in bond markets? There are only a few extreme plunges to test the hypothesis, but limited evidence from Europe suggests they may. . And in the absence of legal or legislative hurdles to encourage the ECB to intervene in bond markets, investors may be forgiven for anticipating such puts.
However, the situation in the United States is different. The Fed’s bond buyback program is relatively new and there are barriers to further intervention. Nevertheless, the Fed has opened the door. The final installment of this series explores whether it has reshaped the US bond market.
Don’t miss the first article in this series.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect those of CFA Institute or the author’s employer.
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