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Trading ECB Corporate Bond Purchases

“Every culture has a myth of decline from some golden age, and almost all peoples throughout history have been pessimists. Even today pessimism still dominates huge parts of the world. An indefinite pessimist looks out onto a bleak future, but he has no idea what to do about it. This describes Europe since the early 1970s, when the continent succumbed to undirected bureaucratic drift. Today the whole Eurozone is in slow-motion crisis, and nobody is in charge. The European Central Bank doesn’t stand for anything but improvisation: the U.S. Treasury prints “In God We Trust” on the dollar; the ECB might as well print “Kick the Can Down the Road” on the euro. Europeans just react to events as they happen and hope things don’t get worse.”

—Peter Theil, Zero to One

If the ECB were a chess player, it doesn’t appear to have a real grasp of opening theory and an awkward feel for the initiative and attack. But it is persistent, can exploit minute advantages, and can gambit its way out of the Teutonic specialty of python-like strangulation.

The ECB’s line of play is indecisive and prone to blunder but growing bold as of late. There is a need for bold fiery play, of course, with the failed Syriza Defense broken by the Schäuble Attack. Don’t get me wrong, it is still anything but a lively game yet. It’s boring and somewhat amusing and incomprehensible like the 5-10 minutes of a Twilight movie I watched before I flipped the channel. BUT… the ECB is taking corporate bond purchases seriously.

Creditflux reports that the ECB has expanded the list of corporate bonds to its list of eligible securities for purchase. Given the lively title of PSPP (short for public sector purchase program), the names consist of utility and energy distribution companies, supranational funding conduits, and various state-owned enterprises. Not much, but it is a start. It puts a non-material bid on a small universe of bonds, but more importantly, it creates an expectation that an expended set of corporate paper could be eligible for ECB purchase in the not-too-distant future.

This tidbit opens up some interesting lines of play. It is contingent one’s view of Greece’s impact on Eurozone capital markets. Insurance companies. Because bonds.

The insurance business is a spread business. It depends on a generalized carry trade: borrowing at an interest rate that is lower than the interest rate that you earn. In the insurance world the insurance companies borrow from policy holders via the premium income received, effectively borrowing from policy holders. The insurance company takes that money, invests in bonds, stocks, and private equity but promises to pay you when an event under contract happens—hopefully the event is infrequent and uncorrelated across the universe of all policy holders, so something like the central limit theorem holds.

The investment return that the insurance company earns on the money that it borrowed from its policy holders minus the payments made to policy holders is the spread for the insurance company.

So if an insurer buys bonds to pick up spread, then the mere expectation of ECB corporate bond purchases will generate price appreciation and greater carry.

As with all things, there is a potential fly in the ointment called Greece. A Greek bond default or a Grexit or some other variant of these could lead to something more than a sell-off or buying opportunity. Contagion across Europe could blunt expectation of any meaningful impact.

The market doesn’t think so. Have a look at what credit thinks about prospects for one of the largest insurers in the world: Assicurazioni Generali. Spreads on Generali show that CDS premium spreads are 1) nothing like the last Euro crisis in 2011 and 2012, 2) elevated above premium seen prior to the 2008 crisis, and 3) reflect concerns about Greece, but nothing like a full-on meltdown.

Source: Hellebore Capital Management

Most post-crisis trades have this feel. A vig that makes sense because you can front-run some price insensitive buyer (yes, I’m talking about a central bank), peppered by possible downside that motivates the price-insensitive buying in the first place. This is the spank of truth.

I’ve seen so many “probabilities” about the likelihood of Greece default or Grexit. Everyone of them is made of unicorn vomit or botfly larvae or heaven forbid the confederate flag. No one has a bloody clue about this until the referendum vote. I wish that pundits would just be honest and admit that underlying every trade has an irreducible gamble at its core.

That’s what’s crackin’.

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