No One Knows How Corporate Europe Will Use its Bond Market Binge --- Including the ECB

Months after the European Central Bank said it would begin buying corporate bonds, investors are still trying to digest what it will mean for the region’s companies and markets.

So too, it seems, is the ECB itself.

Though the ECB has yet to buy a single corporate bond, companies have already been issuing more debt ahead of June, when the central bank will begin buying. So far, the ECB admits it doesn’t know what the new money will be used for.

“The purpose of such issuance also remained to be understood, whether related to funding investment projects, M&A financing or liability restructuring,” the ECB’s governing council noted in the minutes of its latest meeting.

A spokesman said that ECB has conducted no further research on how the rise in corporate bond issuance would be used by the companies involved.

How corporate Europe chooses to use this financing windfall could affect markets and the economy for years to come.

The ECB’s relaxed attitude to how the scheme will influence corporate behavior is sharply different to when the bank began buying sovereign bonds in early 2015, pushing down borrowing costs for governments across the continent. The ways that governments may have used or abused lower interest rates was a key concern of many ECB policymakers at the time.

Far less thinking seems to have gone into how companies will use the cheaper debt driven by the newer Corporate Sector Purchase Program.

Yet there are fewer controls on this scheme. The ECB can only buy sovereign debt in the primary market and only 33% of any individual issue. The ECB will be able to buy corporate debt in the primary market and it may also buy up to 70% of any corporate issue.

As spreads fall in anticipation of the buying, companies are taking advantage. More euro-denominated corporate bonds have been issued in the first five months of this year than for the same period in any year since 2009.

Bank of America Merrill Lynch believes that Europe’s corporate debt market could double in size by 2021, implying €2.5 trillion in issuance over the next five years. The bank believes that an increase in merger and acquisition activity will be the “most visible consequence” of the upswing.

A debt fueled M&A boom would be a break from the past for European companies, who have been more reliant on equity issuance to fund buyouts than their U.S. peers. When companies do use debt to fund takeovers, they often look to banks for syndicated loans, rather than bond markets.

So far companies have shown little appetite to increase M&A. The total volume of M&A in Europe fell 43% during the first quarter of the year from the same period in 2015. Equity capital markets have also been quiet, suggesting companies haven’t been penciling in much M&A activity later in the year. That’s not to say that cheaper debt won’t spur them on, but the signs don’t point that way so far this year.

Analysts also don’t believe the money will be used to invest.

From 2010 to 2015, annual capex growth for companies in the Euro Stoxx index has averaged just 1.8%. Analysts are predicting that investment spending will fall 4.05% this year, the worst drop since 2009, according to FactSet. Analysts are also penciling in slight decreases for 2017 and 2018.

If analysts turn out to be right about investment, and European companies also remain cautious on M&A, then only one of the options listed by the ECB is left: refinancing.

Weak corporate earnings make the opportunity to refinance at cheaper rates particularly attractive. The bonds listed on the iBoxx euro-non financials index have an average coupon of 2.8% while their average yield in the market is just 1.2%.

If companies where to refinance that debt at those yields, that would boost European earnings by a whopping 11%, according to equity strategists at UBS. In other words, companies would be saving money by cutting their interest payments.

Bonds mature over a number of years, so an overnight transformation isn’t possible. But UBS estimates that if companies where to refinance as bonds come due that would still boost earnings by 1% to 1.5% per year until 2020.

How ambitious companies are looking to be will determine how the ECB’s corporate bond buying pans out. If companies are determined to break out of their earnings rut with grand plans for M&A and investment, that explosive increase in the size of the European corporate bond market may happen, just as the ECB wants.

But if the eurozone’s companies take a conservative approach, and use the money to just refinance old debt, the central banks latest program may fall flat.