ABS and Central Bank Tapering
13 July 2017 by Ben Hayward
There has been a lot of focus recently on when the ultra-loose monetary policy world we live in this side of the Atlantic will change. This has caused significant changes in pricing in fixed-rate fixed income products recently, with the 10yr Bund down 4.5pts – so much for a “risk-free” bond!
The ABS market has sailed through this volatility virtually untouched, with neither the new issue nor secondary markets showing signs of contagion – as you might expect of a floating rate product. With most focus currently on the rhetoric surrounding the interest rate environment, we must ask what other forms of stimulus have been implemented that could be turned off, and what impact this could have on the ABS market?
The direct stimuli that have affected the European ABS market have been the ECB’s ABS Purchase Programme (ABSPP), and the inclusion of ABS as eligible collateral in various central bank funding schemes, but it is the former that has seen some speculation more recently around its longevity.
To recap, the ABSPP was first mooted in early summer 2014, confirmed in September of that year, and subsequently launched in November 2014, at around the same time as the 3rd Covered Bond Purchase Programme (CBPP3). At the time, the ECB was focussed on ABS and Covered Bonds as asset classes that could provide funding into the real economy, rather than merely putting money into the hands of the banks. The assumption seemed to be that if the ECB bought ABS, it would be funding lending to consumers and SMEs, which would stimulate further lending from the banks, which the ECB could then also fund.
Soon however, the aim seemed to align itself more with the subsequent implementation of the Public Sector Purchase Programme (PSPP) and the Corporate Sector Purchase Programme (CSPP), which seemed more focussed, alongside the negative rate policy, on supressing yields and forcing investors to take cash off the sidelines and put it to work in higher risk, and higher growth asset classes.
In any case, whatever the specific aims of the programme, the main disappointment is that at the end of June 2017, nearly 3 years since its launch, the ABSPP had only €24bn of holdings in comparison to €222bn (CBPP3), €97bn (CSPP), and €1.6tn (PSPP) in other programmes. This has been because ABS requires more detailed analysis, and that work was initially outsourced to external managers via the national central banks, resulting in a very laborious process.
So, if the size has underwhelmed, has the impact on yields in the ABS market been material? Well, maybe is the answer. Why only maybe? It is difficult to tell as other factors are in play, not least the other programmes reducing yields across the broader markets, which will certainly have helped reallocate investor cash to the higher spread, lower default-rate ABS market.
On top of this, other central bank tools such as repo operations (both standard, and non-standard) and specific mechanisms such as Funding for Lending/Term Funding Schemes have also had a dramatic impact on reducing the available supply of bank originated bond market issuance, and therefore investment opportunities; cheapening the cost of funding for banks in general. This last point must not be overlooked, as the problem with bank lending since the ABSPP was launched has seemed to be much more to do with bank capital levels than bank funding costs. This can be seen in the stronger banking markets such as the UK and the Netherlands, where well capitalised banks, funding at ridiculously low levels, have pushed down mortgage rates to exceedingly low levels. Either way, less ABS issuance has helped the product to tighten as demand has outweighed supply.
What other benefits have been felt? At the time of the launch, the ECB and the BoE were both busily singing the virtues of the ABS market (funding the real economy, providing diversity to bank liabilities, offering high quality investment opportunities to real money investors), and to have omitted it from the suite of QE options would have been hypocritical and almost tantamount to once again branding it as “toxic”. It cannot be understated how the image of ABS has changed in investors’ minds – something we have largely been promoting at TwentyFour for years, but the support of the central banks has been invaluable.
So what would happen then if the ECB announced they were going to stop buying for the ABSPP now? Well I think the market for senior ABS would be a bit less liquid, mainly as investment banks would be losing a counterpart, so their provision of liquidity would be reduced. I think this is quite natural – a buyer stopping buying has that effect. However, I am definitely not saying the senior market becomes illiquid at all, and there were no significant liquidity issues prior to the programme being introduced. As a collateral instrument, bank treasuries would still love holding a high quality credit that can be readily financed with the ECB/BoE, and the trading desks are very low in inventory at the moment, so any reduction there would be muted.
Some of the tightest sub-sectors, which have traded at negative yields, might widen on consideration that this could be a step towards a more normalised environment.
Given the range of funding options, and cheap ones at that, that banks currently have available to them, it would still seem unlikely that issuers would be forced to issue, nor that without the ECB buying that ABS spreads would be forced wider. As we understand it, most banks are very well funded for a number of years, so if the ECB stops buying their ABS deals then it’s no skin off their nose.
The main concern left therefore is the messaging about any change. If the ECB stops buying and the market assumes this is part of a wholesale change to QE, and imminent renormalisation of policy, then the impact on sentiment across all fixed income markets would be akin to what has so far been confined to duration-sensitive fixed rate bonds recently. However, this would seem to be very unlikely, as the main driver here appears to be shuttering the programme that has been the most work for the least reward. There have been some calls from ABS market participants recently to end the programme, and perhaps this will be part of the messaging to ensure that there is no knock-on broader credit market disruption, which would undoubtedly affect all spreads, including ABS.
If it’s handled well (and Mario Draghi has never been rash in his actions so we certainly don’t expect him to start now), our main expectation might be a marginal widening, perhaps reflecting the current basis between deals that are ECB eligible and those that aren’t, but without a material change in sentiment amongst ABS investors as a reaction to such news.
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