Hot on the heels of the ECB, who announced quantitative easing for corporate bonds earlier on in the year, the Bank of England announced in August that it would be commencing its own £10 billion Corporate Bond Purchase Scheme (CBPS) in an attempt to stimulate the UK economy.
The scheme has just started, beginning on the 27th September 2016 and is scheduled to continue for 18 months, with the bank looking to purchase up to £10 billion of corporate bonds from companies ‘making a material contribution to the UK economy’.
What is quantitative easing?
Quantitative easing (QE) is a form of monetary policy whereby a central bank expands its balance sheet and uses the cash created to buy financial assets such as gilts and corporate bonds.
In the past, the Bank of England has carried out quantitative easing using UK Government bonds, with the hope that purchasing gilts will drive the price up, and in turn the yield down. Lower gilt yields should spark a movement into riskier assets (such as corporate bonds and equities) with higher, more attractive yields. Theoretically, portfolio re-balancing into riskier assets should increase the amount of capital that companies have, and therefore increase liquidity and stimulate the UK economy.
Why Corporate Bond QE?
In the past, government bond QE programmes haven’t always worked. This graph (click here) shows the yield of a generic 10 year gilt, with the red areas representing periods of quantitative easing. In 2009 when the Bank of England embarked on QE following the financial crisis, 10 year gilt yields started to rise. This was a trend that was repeated more recently in 2016.
Increasing gilt yields have the opposite to the desired effect. Attracted by increasing yields and security, investors stay in government bonds, and corporate bond spreads over gilts widen. Companies therefore do not reap the benefits and the economy continues to stall.
The Corporate Bond Purchase Scheme should help to ‘cut out the middle man’. Purchasing £10 billion of corporate bonds should drive the price of corporate bonds up and therefore yields down, reducing the spread over gilts (which should be falling simultaneously due to government bond QE).
If yields fall, companies may be able to issue more debt at lower costs. The aim is that capital raised from the issuance of more debt will (theoretically) be used in ways that will boost economic growth, such as on machinery, hiring and innovation.
Will it work?
There are several concerns as to whether the CBPS will be effective. The success of the scheme relies heavily upon companies investing the money in ways that boost economic growth, and not using it to pay out dividends or take over other companies. The temptation for companies is that investing in the ‘real economy’, such as in technology or new projects can be risky, but paying out larger dividends to shareholders is a safe option.
Historically, companies have had to perform well in order to be able to issue debt that is affordable for them. If investors fear that a company is likely to default, they are less likely to buy bonds from them, which drives the price of bonds down and yields up, and therefore makes the bonds expensive for the issuer. The concern is that as bonds become cheaper for companies to issue, the need for companies to perform well diminishes, and this could exacerbate the productivity problem that the UK seems to be in the grip of.
It is clear that companies, unsurprisingly, are jumping at the opportunity of cheaper borrowing. Bond issuance by companies in the UK topped £4.5 billion in August, compared with £3.6 billion in July. However despite the surge in new issuance over the past month, the sterling denominated bond market remains small (£285 billion), especially when compared with the likes of the dollar ($4 trillion) and euro denominated markets. Although the Bank of England has previously purchased corporate bonds for QE, the amount bought only amounted to 1% of the £375 billion programme. We wonder what the effect of a further £10 billion QE programme will be?