Europe Faces Worst Corporate Credit Supply Squeeze Since 2005

(Bloomberg) -- The amount of corporate bonds investors can trade in Europe is shrinking for the first time since 2005.

Despite a rush in deals by high-grade non-financial firms, there’s effectively a 21 billion-euro ($25 billion) drop in the investable pool of euro bonds because of calls, buybacks, upcoming redemptions and European Central Bank debt purchases, according to Bloomberg calculations.

Dwindling supply will typically limit liquidity in credit markets, making the pricing of risk more challenging. The issue is already prevalent in Europe’s sovereign bond market, where central bank dominance has sapped volatility, crimped trading volumes and squeezed out investors in what’s known as “Japanification.”

“It’s getting to a situation where the credit market will be almost broken,” said James Vokins, head of investment-grade credit at Aviva Investors, which oversees 366 billion pounds ($505 billion). “It won’t be functioning with the liquidity it needs and that could be a concern for next year if the trend continues.”

So-called negative net-net supply is the result of continuing central bank stimulus in a period when companies have limited funding needs after the 2020 debt binge. Firms in the euro area boosted cash reserves during the pandemic and now sit on record-high deposits with banks. Gross supply of euro non-financial bonds has seen a 42% year-on-year drop, according to data compiled by Bloomberg. 

Read more: Firms Hoarding Cash Like Never Before Ease Credit Nerves

While the ECB decided last week to slow down the pace of purchases under its pandemic emergency purchase program, or PEPP, the bulk of credit purchases take place under the corporate sector purchase program, known as CSPP, which has been in place since 2016.

Net-net issuance in the euro area is expected to remain negative for most of the fall. Barclays Plc strategists Zoso Davies and Jenny Avdoi forecast negative net supply after ECB purchases in each of this year’s four remaining months, apart from November. That’s even after brisk gross supply of 32 billion euros they’re expecting in September. 

Japan’s Example

A far-fetched example of limited free-float can be found in the Japanese government bond market, where the lack of liquidity is so extreme that there were zero trades in the 10-year benchmark one day last month despite there being a bond auction. 

A supply comeback could still be in the cards in Europe, as sales over the longer-term will probably increase as companies pare cash piles. 

At least for now, negative net-net supply makes it easy for cash-rich investors to absorb the new issuance and helps keep risk premiums in corporate debt near historically low levels. Spreads have flatlined at about 83 basis points since mid-April, based on Bloomberg index data.

Fierce competition for bonds means portfolio managers either have to buy whatever they can at any price or risk getting stuck with idle cash.

“The situation currently in the new issuance market makes it difficult to get paper for a reasonable premium,” said Thomas Neuhold, a portfolio manager at Gutmann Kapitalanlage AG, which oversees 10 billion euros. “You’re trying to set spread limits and effectively end up sitting in cash.”

Europe

Primary market participants are predicting another heavy week for sovereign, supranational and agency issuance, aided by the debut green gilt for the U.K., according to a survey conducted by Bloomberg News on Sept. 17.

• Monday saw three borrowers looking to issue at least 1.9 billion euros of debt
• The U.K.’s debt management office plans to offer a green gilt due in July 2033 on its first foray into the region’s green bond market
• Emerging-market bond sales are springing back to life before this week’s Federal Reserve meeting, as renewed speculation over imminent tapering prompts borrowers to raise money while it’s still cheap
• European banks’ riskiest bonds known as Additional Tier 1s “look favorable” relative to high-yield bonds, particularly in euros, according to Barclays strategist Bradley Rogoff
• Yannik Zufferey, chief investment officer for fixed income at Lombard Odier Investment Managers, is relatively cautious on investment-grade credit and sees more attractive opportunities in the high-yield sector

Asia

Contagion from China Evergrande Group is spreading in Asian credit markets as the distressed developer and largest issuer of junk bonds in the region faces interest payment deadlines.

• The average price of high-yield dollar notes from Chinese borrowers slid some 2 cents Monday, set for the worst decline in about a year. That dragged down prices in the broader market for Asian junk bonds by 1-2 cents, traders said
• Goldman Sachs researchers, led by Hui Shan, said in a note dated Sept. 19 that Evergrande’s problems should be manageable, though its size makes the impact hard to assess
• Even debt with investment-grade ratings was stung. Yield premiums on notes from Country Garden Holdings Co., China’s largest developer by sales, widened to a record

U.S.

Bond bears, long frustrated by stubbornly low Treasury yields, are girding for a make-or-break week as the Federal Reserve is expected to start laying the groundwork for reducing stimulus.

• The bond market enters this potentially pivotal stretch at a crossroads: 10-year yields are testing the top of their range since early July as traders anticipate that the Federal Open Market Committee will hint in its Sept. 22 decision at a plan to curb its bond buying
• A deluge of leveraged buyout debt has been building up for months and is finally set to hit the high-yield market
  • Meanwhile, high-grade bond supply should moderate, with Wall Street calling for $20 billion to $25 billion of sales, according to an informal survey of debt underwriters

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