On April 30, 2020, the European Central Bank (ECB) announced expanded measures aimed at further incentivizing banks to channel liquidity to the wider European economy. It was the latest in a series of actions since the onset of the COVID-19 pandemic aimed at containing market volatility and facilitating market liquidity. The central bank's twin-pronged approach, combining direct asset purchase programs alongside credit-easing measures aimed squarely at facilitating bank lending, has led to a surge in bond issuance and a significant increase in bank lending to corporates. However, the recovery in funding conditions has been uneven: certain primary markets, most notably high yield, are proving slow to recover, and financing costs remain elevated.

In our view, the ECB measures and bank funding, in part supported by national support schemes, will underpin corporate markets through this economic crisis and are likely to be critical in stabilizing corporate funding markets in the months ahead.

S&P Global Ratings acknowledges a high degree of uncertainty about the rate of spread and peak of the coronavirus outbreak. Some government authorities estimate the pandemic will peak about midyear, and we are using this assumption in assessing the economic and credit implications. We believe the measures adopted to contain COVID-19 have pushed the global economy into recession (see our macroeconomic and credit updates here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

The PEPP Steps Up

As the effects of the COVID-19 pandemic unfolded and market liquidity began to seize up in March, the ECB stepped in to augment its existing asset purchase programs, such as the corporate sector purchase program (CSPP), with the launch of the Pandemic Purchase Emergency Program (PEPP). This program, expected to have a short life span, has a broad remit and significant resources, with the ability to purchase up to €750 billion in securities until the end of the year.

The corporate aspects of the PEPP largely mirror the existing CSPP: it includes both long- and short-term paper issued by nonfinancial European corporates, the key eligibility criteria includes a minimum rating of 'BBB-' and a maximum maturity at time of purchase of 30 years. However, the PEPP expands the range of eligible assets to include nonfinancial commercial paper, ensuring all commercial paper of sufficient credit quality is now eligible for purchase.

While the CSPP holdings amounted to €207 billion as of April 30, 2020, and the net amount has increased steadily in recent months, it is now dwarfed by the size and scale of the PEPP, which already amounts to €119 billion after just two months (see chart 1). No breakdown of purchases by sector type is yet available, and Christine Lagarde, the ECB's president, indicated during her latest press conference that the ECB will only provide such information on a bi-monthly basis. However, if we assume purchases will break down similarly to the asset purchase programs, the ECB could purchase an additional €4 billion of corporate bonds per month. This would mean purchases of investment-grade corporate securities could potentially double in the months ahead.

Chart 1

Investment Grade Surges, Speculative Grade Stutters

The introduction of the PEPP had an immediate impact on issuance and yields because the ECB effectively signaled its intent to materially ramp up its role as a critical investor and also its wider commitment to containing market volatility and avoiding a credit crunch in the eurozone private sector. The increase in the volume of corporate bond purchases provided much-needed confidence to wider markets, and has subsequently underpinned financing conditions.

Investment-grade issuance surged in March (see chart 2) following the initial announcement and similar actions by other central banks, most notably the Fed and the Bank of England. European nonfinancial corporate investment-grade issuance to April 30 already amounted to €128 billion, including €56 billion in April alone, easily surpassing the total for the same period in 2019.

However, the surge in investment-grade issuance is only partially explained by increased purchases on behalf of the ECB. Many investment-grade issuers have simply taken advantage of the calmer and less volatile market conditions created by ECB intervention, and accepted higher financing costs to shore up liquidity buffers to counter severe operating challenges caused by the pandemic and associated uncertainty on the timing and strength of the recovery.

Chart 2

In contrast to investment-grade issuers, recent speculative-grade issuance has struggled. Most of the €21 billion issued until April 30 took place prior to the COVID-19 lockdowns. While there has been a pick-up in recent weeks, primary markets remain largely shuttered (see chart 3). This is in stark contrast to U.S. high-yield markets, where April issuance was the third-highest total ever, buoyed by the Fed's decision in April to include certain fallen angel debt and speculative-grade exchange traded funds (ETFs) within the remit of its purchase programs. This leaves speculative-grade companies reliant on existing sources of funds, primarily sponsors, committed lines of credit, and their relationship banks.

Chart 3

Chart 4

The exclusion of speculative grade from PEPP to date no doubt has not helped the case for speculative-grade primary market issuance in Europe. However, as ECB actions have served to stabilize speculative-grade market spreads and improve pricing, it is somewhat surprising that this has not been enough to date to reopen primary markets meaningfully, despite anecdotal evidence of strong buy-side liquidity.

A combination of factors could be at play here, including issuer reticence to lock in elevated financing costs, lack of investor appetite for vulnerable sectors most in need of additional liquidity, and the increase in bank financing that has reemerged in recent months alongside national support schemes established by EU member states.

A Starring Role For Bank Financing Supported By National Support Schemes

Alongside the introduction of the PEPP, the ECB and relevant authorities have introduced a number of other supportive measures. These have included easing the conditions for accessing long-term refinancing operations and providing more flexible regulatory support to ensure liquidity continues to flow to the private sector. We therefore expect that European banks will play a pivotal role in channeling funding to meet solvent corporates' financing requirements through the extension of credit lines and other borrowing facilities. Unlike in the 2008 global financial crisis, European banks have approached this turn in the economic cycle with significantly strengthened capital and liquidity positions.

We believe the ECB's April 2020 Bank Lending Survey of eurozone banks points to an expected increase in bank lending to businesses over the next six months. Surveyed banks anticipate that demand for new credit, mostly short term, from small and midsize enterprises (SME) and, to a lesser extent, large corporates is likely to rise during the course of the year (see chart 5). They also anticipate they might ease somewhat their credit standards in response to higher borrowing requests from corporates, and potentially the presence of national support schemes. The additional measures announced more recently by the ECB, including the 25 basis points (bps) further reduction in the targeted long-term refinancing operations (TLTRO) rate for banks and the launch of the new PELTRO (pandemic emergency long-term refinancing operations), could provide an additional incentive for banks to continue funding businesses across eurozone countries.

Chart 5

Recently released ECB data appears to support the survey results in terms of new lending to the corporate sector. It highlights a stark increase in new loans to nonfinancial corporates (NFC), and a March total greater than the combined total for the previous 10 months (see chart 6).

Chart 6

On first review, this sharp increase in new loans to NFCs, which coincided with increased ECB monetary stimulus, may indicate that the combined efforts to ensure bank lending would not dry up have been effective to date. Nevertheless, it is worth considering the likely composition of this total more closely, as well as other factors that may have contributed to this spike up to now and that could affect further growth in the future.

First, a significant component of the March total is likely to be the direct result of the large-scale drawdown of existing revolving credit facilities by investment-grade corporates, which would be prudent treasury management given the severity of the downturn as companies look to bolster liquidity buffers. The breakdown of the ECB lending data appears to support this: 45% of the new loans to NFCs over the month of March have a maturity of less than one year. More conventional new lending growth is also likely to have been a factor. The ECB lending survey reveals that the primary motive for NFC loan demand over the first quarter was to finance inventories and working capital.

Over the coming months, the advent of national support schemes may also support increased bank lending. National governments have established support schemes in response to companies' demand for assistance through the currently turbulent and volatile market conditions. Take-up across some of these facilities has been significant: German companies had submitted more than 27,000 loan applications under the KFW scheme by April 30, 80% of which related to smaller companies with a credit volume of less than €800,000. While the terms of national programs can vary considerably, a key pillar of them is the significant assumption of credit default risk by governments or government-related entities. KFW in Germany, for example, assumes 80% of the credit risk for larger companies and syndicated financings, covered by a guarantee from the federal government.

There is no clear data outlining the extent to which larger corporates, which would typically rely upon other sources of liquidity, are using the national support facilities. However, recent high-profile examples, including leisure and car-hire companies in Germany and France, show that larger companies are clearly tapping into them. Whether the structures are more suitable, delivery more certain, or pricing more attractive than alternative options remains to be seen. Somewhat counter-intuitively, bank lending alongside comprehensive national support schemes could potentially be a factor contributing to the slower reopening of speculative-grade primary markets.

Regardless of the motives, it is clear that bank financing has increased: outstanding loans to NFC were €134 billion higher in the first quarter (quarter on quarter). This represents a credit impulse of 3.6% of eurozone GDP which has a major countercyclical effect, without which this year's recession would likely be much greater.

An Uncertain Path Ahead With Potential Pitfalls

Although ECB direct asset purchase programs and financing stimulus have been effective in reducing market volatility and improving market sentiment, spreads remain elevated. Furthermore, while the central bank has stated that it is prepared to go further to avert the fragmentation of eurozone debt markets, the further steps that may be taken are uncertain.

Chart 7

The ECB surprised markets last month with the decision to accept fallen angels as eligible collateral when banks seek to access cheap ECB financing. This has led to speculation that this may lead to the inclusion of fallen angels within the PEPP. The decision to include fallen angels was structured to mitigate elevated market volatility and funding stress that a single or stream of fallen angels, whether they be sovereign or corporate, could introduce to financing markets without necessarily increasing the risk to the ECB. This is relevant when considering whether the ECB might extend the PEPP to include fallen angels. Through increased haircuts and margining, the ECB seeks to mitigate any additional risk it takes by accepting fallen angel speculative-grade issuers as collateral. This is very different to its exposure under the PEPP, where it is taking direct credit risk. Further amplifying this, the ECB, as opposed to the Fed, currently takes the exposure directly on its balance sheet, while current PEPP eligibility criteria allows much longer-dated securities than the comparable Fed corporate facilities. These issues do not in any way preclude the purchase of fallen-angel debt as a future measure--and the ECB has already granted a waiver for Greek bonds. Yet, the way in which the ECB elects to manage and structure the increased credit risk would be closely watched by the markets.

Further ECB measures to contain market volatility are also uncertain. The PELTROs might help indirectly to stabilize yields, while speculative-grade pricing might tighten sharply if the ECB considers direct purchases of fallen angels. In addition, investment-grade pricing might become tighter if the ECB considered increasing the size of the PEPP. However, the extent of the ECB's current activity is probably already built into yields, and it could be argued that yields are more vulnerable to widening if markets question the ECB's commitment or ability to underpin financing markets.

This commitment was recently put under a spotlight by the ruling of the German constitutional court. Anything that could potentially constrain the flexibility of the ECB would be negative for funding conditions, but the ultimate outcome will remain uncertain while engagement between the main participants continues during the months ahead. In the meantime, the PEPP is likely to continue, and markets did not react overtly negatively to the initial news. However, uncertainty and unknowns are never conducive to market stability in the long run.

Finally, it remains to be seen whether measures taken to date by the ECB and national authorities will prove sufficient on their own to stabilize corporate funding markets. A contrarian view, on the other hand, would be that the measures might have resulted in too much liquidity being available to certain vulnerable corporates. Some issuers are faced with the dilemma of an urgent need for financing but a less clear path in terms of how they will manage the increased leverage and financing costs at a time when revenues are under severe strain. While corporates can avoid near-term stress by taking on additional liquidity, they are potentially storing up bigger challenges in the medium term.

Related Research

• How The Fed Changed The U.S. Corporate Funding Landscape, April 23, 2020
• Europe Braces For A Deeper Recession In 2020, April 20, 2020
• Government Job Support Will Stem European Housing Market Price Falls, May 15, 2020
• EU Response To COVID-19 Can Chart A Path To Sustainable Growth, April 22, 2020
• How COVID-19 Risks Prompted European Bank Rating Actions, April 29, 2020
• European Banks' First-Quarter Results: Many COVID-19 Questions, Few Conclusive Answers, April 1, 2020
• ECB's 2019 Stress Test Confirms Eurozone Banks Have Adequate Liquidity, Oct 10, 2019