Covered Bonds Fall Short in Pimco’s Prophesy for QE: Euro Credit

5/11/2014

By Eshe Nelson and Lukanyo Mnyand

The European Central Bank will relent and buy government debt.

That’s the opinion both of France’s largest bank and the manager of the world’s biggest bond mutual fund. BNP Paribas SA and Pacific Investment Management Co.’s argument is this: There aren’t enough covered bonds and asset-backed securities available to buy for the ECB to achieve its balance sheet goals.

BNP Paribas has gone so far as to provide a blueprint for how its strategists see a quantitative-easing program unfolding. The institution may start buying 400 billion euros ($501 billion) of sovereign bonds before year-end, the bank estimated. Purchases would be distributed in accordance with each country’s contribution to the ECB’s capital, so German securities would be the most acquired, BNP Paribas said.

“It’s very difficult for them to hit their balance sheet target simply by buying covered bonds and asset-backed securities because the markets aren’t big enough,” Myles Bradshaw, a London-based portfolio manager at Pacific Investment Management, or Pimco, said in an interview in Brussels on Nov. 3. “The big market in Europe is the sovereign-bond market.”

With inflation languishing below the ECB’s target of just under 2 percent and data showing the economic recovery ebbing, ECB President Mario Draghi has said his stimulus measures are intended to increase the institution’s balance sheet back toward early 2012 levels -- at least 2.7 trillion euros -- from about 2 trillion euros today.

The Governing Council meets tomorrow in Frankfurt, with economists predicting officials to keep their key lending rates at record lows, according to Bloomberg surveys.
Crisis Assets

Prospects of ECB sovereign-bond purchases underpin Pimco’s favoring Spanish and Italian debt, Bradshaw said.

With the ECB saying it may buy some assets in crisis-hit Greece and Cyprus, which have a debt rating below BBB minus, the possibility was opened up for future purchases of their government bonds, according to Ioannis Sokos, a fixed-income strategist at BNP Paribas in London.

“QE seems more likely and our economists now expect it to happen at some point, maybe even before the end of the year,” Sokos said in a telephone interview on Nov. 3. “Inflation keeps disappointing to the downside. What they have announced so far does not seem strong enough to achieve expanding its target by a considerable amount. At some point you will need to expand your pool of asset purchases.”
Nowotny’s View

Governing Council member Ewald Nowotny said the central bank shouldn’t start buying sovereign bonds this year and warned against giving in to financial market pressure. Instead, it needs to assess the impact of steps already taken, he said in an interview with Nikkei newspaper published Nov. 4.

In a QE program, the ECB would buy sovereign bonds in line with euro nations’ capital contributions to the central bank, which would mean buying large amounts of German bonds, a step the nation doesn’t need, said Nowotny, who also is the head of Austria’s central bank.

Speculation of coming purchases has given investors one more reason to buy euro-area debt. Germany’s 10-year yield fell to a record-low 0.715 percent on Oct. 16. It’s five-year rate fell to as little as 0.080 percent last month, while that of two-year debt is less than zero, meaning investors are paying to lend to Europe’s largest economy.

Italy’s two-year yield was as low as 0.211 percent in September, compared with as much as 8.121 percent in November 2011. It was at 0.73 percent as of 8:35 a.m. London time.

The drop in borrowing costs prompted Italian debt chief Maria Cannata to question the usefulness of QE, saying in Brussels this week that she was “a little bit skeptical” that this step was needed or necessary.
Economists’ Expectations

More than half of the economists in Bloomberg’s monthly survey published on Oct. 13 predicted Draghi would eventually announce a QE program of government-debt purchases. That’s up from about a third in September.

The ECB most probably would buy bonds with maturities of one to three years, taking the equivalent of about 30 percent of the outstanding euro-area securities in those tenors, BNP Paribas says. The central bank would purchase, for example, 108 billion euros of Germany’s debt, 71 billion euros of Italy’s and 11 billion euros of Greece’s, according an Oct. 30 analyst note.

The outstanding amount of covered bonds purchased under the Frankfurt-based institution’s program rose by 3.075 billion euros last week to 4.779 billion euros, data on the ECB’s website showed on Nov. 3. The purchase plan is set to broaden before the end of the month to include asset-backed securities.

“Volume of asset purchases in the other segments is too small, while deflationary risks persist,” said Daniel Lenz, lead market strategist for the euro area at DZ Bank AG in Frankfurt. “Regarding countries, many options are possible. One would be to take the ECB quota, but the ECB could also concentrate on certain countries.”

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