The sterling corporate bond market is the worst place for QE
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The sterling corporate bond market is the worst place for QE

Carney 4 aug 2016 PA 230x150

When the Bank of England published the list of bonds it could buy under its new corporate bond purchasing scheme, set to run from the beginning of October, it only underlined how poorly suited the sterling corporate capital market is for extraordinary monetary policy.

Quantitative easing can work (or fail to work) in several different ways. It can lower the cost of capital for companies, stimulating investment and job creation. It can lower the cost of debt service for governments, easing fiscal pressures. Buying assets from banks with newly created money lowers their total risk weights, boosting capital ratios. Buying assets from investors pushes them out of safe assets and into risky ones, which presumably fund more entrepreneurial activities.

By any of these standards, though, the sterling market (and the UK economy) is badly arranged.

Decades of open capital markets (and openness to multinationals) has meant that some of the UK’s biggest manufacturing operations barely touch the sterling market.

The Nissan plant in Brexit-voting Sunderland is funded mostly by parent Renault, with no eligible bonds. UK plc stalwarts like AstraZeneca (one eligible bond), BAE Systems (one bond), BP (also one bond), Shell (yup, one bond) and Unilever (you guessed it — one bond) mainly fund in the deeper capital markets in euros and dollars.

The ECB is also doing all it can to lower their funding costs, but it’s vanishingly unlikely that any such will make a big new UK investment on the back of the lower cost of sterling debt now on offer. When they hit sterling at all, it is because the basis swap works for them.

When they do big, debt fuelled acquisitions, such as when Shell bought BG, earlier this year, such firms look outside the UK for the funds to do it. And, even then, if an acquisition only works because debt costs came down 100bp, it’s probably not a good acquisition in the first place.

Looking through the rest of the Bank’s list, it’s striking how many of the issues come from utilities. The Bank’s sector key, which will guide purchases and prices, is 25% electricity, 8% water, and 7% gas. If you throw in rolling stock owners like Eversholt, plus public transit franchise firms like Deutsche Bahn and Firstgroup, the figure for utility-like issuance creeps higher still.

These firms are, if anything, even less likely to expand thanks to lower capital costs in sterling — because they can’t. Building new rail or power infrastructure is mostly a political decision, and the high profile fights over Hinkley Point and the High Speed Two railway show those are not easy ones to make.

Many of the utility operators are monopolies with their returns capped by legislation, and have structured their funding around the cap, with high leverage but secured or quasi-secured debt based on the solid cashflows from a protected utility franchise. There’s simply no prospect of major growth or job creation driven by regional water monopolies.

The question of where to buy the bonds is also somewhat vexed, in the UK. The funding ratio of pension schemes is much higher in the UK than in most of continental Europe (the Netherlands is a notable exception), meaning buying bonds, either in corporates or Gilts, has a much more direct impact on the funding gap for UK pensions. If, like much of Europe, you don’t even try to match your pension liabilities, the gap is less of a worry.

That doesn’t mean the whole project is hopeless.

If the UK is a bad place to run corporate QE, it’s far better than most of the eurozone to run an asset-backed purchase programme. The UK economy is intensely sensitive to mortgage availability, and has an active, sophisticated RMBS market, while it also boasts some of the best loan data in Europe. SME ABS has been a non-starter in Europe, hamstrung by the difficulties of making such a disparate asset class “simple and transparent”. But the UK has seen virtually the only post-crisis issuance of SME bonds.

The Bank of England, to its credit, has led Europe on pushing for loan level data, transparency, and the revival of securitization, while it has also encouraged banks to preposition whole loan collateral at the discount window, in the process developing the expertise needed to evaluate and purchase such assets.

In short, the Bank's approach to easing monetary policy this time is almost exactly the wrong way around. Stimulating the economy through buying ABS could really work in the UK; corporate bonds almost certainly cannot.

But if the Bank just wanted to signal to the markets that everything was under control? Then it doesn't matter whether it works or not. Mr Carney pulled something out of the hat; just don't look too closely to see if its ears are big enough.

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