LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET IMPACT OF THE END OF NET PURCHASES OF THE APP - ECB BMCG, 12th February 2019

 
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LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET IMPACT OF THE END OF NET PURCHASES OF THE APP - ECB BMCG, 12th February 2019
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
ECB BMCG, 12th February 2019

Oliver Eichmann (DWS)

For Professional Clients (MiFID Directive 2014/65/EU Annex II) only.
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Euro Covered Bonds - Market Structure Developments
COVERED BOND INVESTOR BASE AND ESCB’S MARKET SHARE                                NET NEW ISSUE DEVELOPMENTS & INFLUENCE OF THE ESCB
Amount of ECB eligible bonds in million €. % of ECB eligible bonds outstanding    in billion €
800,000                                                                     60%
700,000
                                                                            50%    200
600,000
                                                                            40%               145           153
500,000                                                                                     143
                                                                                   150                                      130                137         135
400,000                                                                     30%                               128
                                                                                                                              113
300,000                                                                                                                                                   102
                                                                            20%
200,000                                                                            100                                                     87
100,000
                                                                            10%
                                                                                                                                                 50
       0                                                                    0%       50                                                                         33
           Jan 15

           Jun 15

           Jan 17

           Jun 17

           Jun 18
           Sep 14

           Dec 15

           Aug 16

           Nov 16

           Sep 17
           Dec 17

           Sep 18
           Dec 18
           Oct 15

           Oct 16
           Mar 15

           Mar 16

           Mar 17

           Mar 18
                                                                                                                                                      6          11
                                                                                                   2
                                                                                      0
           Private investors                       CBPP1
           CBPP2                                   CBPP3
           CBPP 1-3 share (RHS)                                                                                                   -17
                                                                                                                  -26
                                                                                    -50
Source: Credit Agricole, as of January 2019
                                                                                                                                    -72
                                                                                  -100
_ Covered Bond market structure has changed since the                                                               -97
  start of CBPPs.                                                                                   -115
                                                                                  -150
_ The ESCB has become the dominant buyer. The investor                                           2015          2016             2017           2018        2019e
  base in this market segment changed over time
_ With a market share of around 40% and the persistent                                 Redemptions         Gross issuance       Net issuance    Net issuance after QE
  presence of central banks in these markets the bargaining
  power of sellers relative to buyers has significantly
  changed                                                                         Source: Credit Agricole, as of January 2019

Oliver Eichmann (DWS), February 2019                                                                                                                                  2
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Euro Covered Bonds – Transaction Costs in a Changed Market Structure
LIQUIDITY COST INDICATOR® - DECLINING TRANSACTION COSTS                          BID-ASK SPREADS FOR 5 YEAR COVERED BONDS
LCS in %*                                                                        Spread in % of par value
 1.000                                                                            0.1600
 0.900
 0.800
 0.700                                                                            0.1400
 0.600
 0.500
                                                                                  0.1200
 0.400
 0.300
 0.200
                                                                                  0.1000
 0.100
 0.000
     Sep-12      Sep-13      Sep-14     Sep-15      Sep-16     Sep-17   Sep-18    0.0800
                                            LCS Euro Covered
LCS=(Ask price –Bid price)/ Bid-price
Source: Barclays Bank, as of January 2019
                                                                                  0.0600
_ Transaction cost measures such as Bid-Ask spreads and
  liquidity cost scores signal no deterioration in the overall
                                                                                  0.0400
  liquidity situation, rather the opposite
_ The length and size for the CBPP programs suggest that
                                                                                  0.0200
  the covered bond market has become a „sellers market“
_ Anecdotal evidence suggests that while the overall
                                                                                  0.0000
  liquidity premiums have been reduced it became more                                  Oct-14            Oct-15           Oct-16      Oct-17    Oct-18
  difficult for potential investors to source bonds (at least
  without increasing market prices significantly)                                            FR 5Y           DE 5Y            IT 5Y   NL 5Y    ES 5Y

                                                                                 Source Credit Agricole, as of January 2019

Oliver Eichmann (DWS), February 2019                                                                                                                     3
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Euro Covered Bonds – Trading Volume in a Changed Market Structure
TRADING VOLUME VERSUS OUTSTANDING DECLINED OVER TIME                                       BOOK TO ISSUE SIZE FELL DESPITE ESCB BUYING

  0.50%
  0.45%                                                                                      2.8
  0.40%
  0.35%                                                                                      2.6
  0.30%
  0.25%
  0.20%                                                                                      2.4
  0.15%
  0.10%                                                                                      2.2
  0.05%
  0.00%
                                                                                             2.0
      Mar-14         Mar-15        Mar-16          Mar-17         Mar-18
          € benchmark trading volume as reported to Trax, in % of nominal
                                                                                             1.8
Source: Commerzbank, TRAX as of January 2019
                                                                                             1.6
_ Volume based measures such as trading volume and book/
  issue size suggest a reduction in liquidity                                                1.4

_ This measure could also point to a „crowding-out“ of „typical“
  covered bond investors that left the market as a result of a                               1.2

  less attractive risk-return profile
                                                                                             1.0
_ Evidence of strategic decisions by institutional investors to
                                                                                                   Jan-13

                                                                                                                              Jan-14

                                                                                                                                                         Jan-15

                                                                                                                                                                                    Jan-16

                                                                                                                                                                                                               Jan-17

                                                                                                                                                                                                                                          Jan-18

                                                                                                                                                                                                                                                                     Jan-19
                                                                                                                     Sep-13
                                                                                                            May-13

                                                                                                                                                Sep-14
                                                                                                                                       May-14

                                                                                                                                                                           Sep-15
                                                                                                                                                                  May-15

                                                                                                                                                                                                      Sep-16
                                                                                                                                                                                             May-16

                                                                                                                                                                                                                                 Sep-17
                                                                                                                                                                                                                        May-17

                                                                                                                                                                                                                                                            Sep-18
                                                                                                                                                                                                                                                   May-18
  reduce covered bond holdings significantly should be taken
  into account when ending the CBBP program
                                                                                                                Book/ Issue Size                                           Book/ Issue Size (12 months rolling)
_ Studies provide evidence of negative effects on market
                                                                                           Source: Credit Agricole, as of January 2019
  functioning by reducing the amount for tradable securities in
  the context of Fed’s purchases of MBS **.                                                ** Kandrac, J. & Schlusche, B. „Flow Effects of Large-Scale Asset Purchases“, Economic
                                                                                              Letters, 2013
                                       Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or
Oliver Eichmann (DWS), February 2019                                                                                                                                                                                                                                          4
                                       analyses, which might prove inaccurate or incorrect
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Corporate Bonds – Liquidity & Spread Developments
BID-ASK SPREAD EURO-CORPORATE BOND MARKET                                                         FLOW MOMENTUM TURNED NEGATIVE IN 2018
                                                                                                 Spreads in bps vs. government bondsFlows in% of retail funds assets under management
in % of par value

                    1.60                                                                          185.0                                                                              0.5
                    1.40                                                                                                   % aum (10wk avg, rhs)            spread (lhs)             0.4
                    1.20                                                                          165.0
                                                                                                                                                                                     0.3
                    1.00                                                                                                                                                             0.2
                                                                                                  145.0
                    0.80
                                                                                                                                                                                     0.1
                    0.60
                                                                                                  125.0                                                                              0.0
                    0.40
                                                                                                                                                                                     (0.1)
                    0.20
                           Bid-Ask-Spread Euro HG         Bid-Ask-Spread Euro HY                  105.0
                    0.00                                                                                                                                                             (0.2)
                           2013-01-31
                           2013-04-05
                           2013-06-10
                           2013-08-09
                           2013-10-11
                           2013-12-12
                           2014-02-18
                           2014-04-23
                           2014-06-26
                           2014-08-28
                           2014-10-29
                           2015-01-05
                           2015-03-06
                           2015-05-12
                           2015-07-14
                           2015-09-15
                           2015-11-16
                           2016-01-21
                           2016-03-23
                           2016-05-27
                           2016-07-29
                           2016-09-30
                           2016-12-01
                           2017-02-06
                           2017-04-07
                           2017-06-14
                           2017-08-15
                           2017-10-17
                           2017-12-18
                           2018-02-21
                           2018-04-26
                           2018-06-29
                           2018-08-31
                           2018-11-01
                                                                                                                                                                                     (0.3)
                                                                                                    85.0
                                                                                                                                                                                     (0.4)
                                                                                                    65.0                                                                             (0.5)
                                                                                                      Mar-13       Mar-14       Mar-15       Mar-16      Mar-17       Mar-18
Grey shaded area – ECB Corp Sector Purchase Program, net purchases ended
December 31st 2018, Source: Market Access, 01.2019                                                Source: DWS Investment, Bank of America, as of January 2019

_ Transaction cost indicators do not signal a material shift                                      LIQUIDITY COST SCORE® – EUR IG & EUR HY
  in corporate credit liquidity                                                                    2.000

_ Spread widening in Q4 2018: Did spread widening trigger                                                                                       EUR IG Credit              EUR HY
                                                                                                   1.500
  outflows? Anecdotal evidence suggest that secondary
  market depth in Euro IG was rather low during this phase                                         1.000
  with generous pick-ups in spreads of new issues versus
  outstanding bonds                                                                                0.500

_ Re-balancing of fixed-income portfolios toward higher                                            0.000
  yielding assets might trigger outflows in a more volatile                                             May-10 May-11 May-12 May-13 May-14 May-15 May-16 May-17 May-18

  environment                                                                                     Source: Barclays Bank PLC, as of January 2019

                                              Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or
Oliver Eichmann (DWS), February 2019                                                                                                                                                       5
                                              analyses, which might prove inaccurate or incorrect
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Price Based Measures – Liquidity Premiums & QE – Empirical Findings
US-TIPS & INFLATION SWAP MARKET* (2010/2011)                                                  EURO-PERIPHERY SOVEREIGN DEBT MARKET (2010)***

_ Study on the Fed’s second QE program (November 2010                                         _ Study on the effects of the ECB’s purchases of peripheral
  to June 2011) for Treasury inflation protected securities                                     sovereign European debt through its Securities Markets
  (TIPS) and inflation swap contracts                                                           Program
_ Study results suggest that TIPS purchases temporarily                                       _ Bonds relative liquidity premiums are measured by
  reduced liquidity premiums in the market for TIPS                                             comparing prices for sovereign bonds and CDS written on
                                                                                                those bonds
_ “Event study analysis demonstrates the purchases
  persistently depressed the liquidity-premium measure by                                     _ “We find that an official purchase of 1% of sovereign
  an average of about 10 basis points for the duration of the                                   bonds outstanding lowers liquidity premium by 32-40 bps
  QE program”. This is a reduction of the liquidity premiums                                    on impact, 13-17 bps of which is lasting”
  of almost 50% from pre QE2 levels
                                                                                              _ If this finding can be transferred to the Public Sector
_ Explanation: QE reduces price frictions in less liquid                                        Purchase Program it would imply that even after the end
  markets as the persistent presence of central banks                                           of net new purchases the liquidity premiums would be
  increases bargaining power of sellers relative to buyers –                                    persistently lower compared to the status quo ante,
  this lowers liquidity premiums                                                                especially as reinvestments continue and the stock of
_ Liquidity premium effects dissipated towards the end of                                       purchases is unchanged
  QE2 purchases. Does this imply that the end of the net
  asset purchases by the ESCB will lead to a similar rise in
  the liquidity premium of the relevant markets?

*Christensen J.H.E.& Gilian, J.M. „Does Quantitative Easing Affect Market Liquidity?“,        *** De Pooter, M., Martin, Robert, F.M., Pruitt, S., „The Liquidity Effects of Official Bond
San Francisco Fed, September 2018                                                             Market Intervention“, Journal of Financial and Quantitative Analysis, February 2018

                                          Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or
Oliver Eichmann (DWS), February 2019                                                                                                                                                         6
                                          analyses, which might prove inaccurate or incorrect
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Focussing on Tails Events – Liquidity in Market Stress Phases
                                                                                           SPIKE IN BTP BID-ASK SPREAD END OF MAY 2018

                                                                                           18
_ Flow momentum in “riskier” parts of fixed-income is                                                                                                Bid-ask spread
                                                                                           16
  positive since several years
                                                                                           14
_ This is probably partly due to negative risk-free rates and                              12
  central bank forward guidance (portfolio rebalancing                                     10
  channel)                                                                                   8
_ Additionally the ESCB is an increasingly dominant market                                   6
  participant in several market segments under the asset                                     4
  purchase programs                                                                          2
                                                                                            0
_ A less experienced and more homogeneous investor                                          Jan-11              Jan-13              Jan-15             Jan-17             Jan-19
  base might follow a similar behavior which could
  potentially amplify a “sell-off” in times of market stress                               Source: Citigroup, as of January 2019
  (“Herding”)
                                                                                           STRONG FLOW MOMENTUM INTO FIXED INCOME ETF
_ Reduced dealers balance sheet and a higher proportion                                    140%
  of e-trading might increase illiquidity in times of market                               120%                    EM
  stress further                                                                           100%
                                                                                                                   Global HY
                                                                                                                   Global HG ex-EM
_ Example: “sell-off” in BTPs on the 29th / 30th of May 2018,                               80%
  especially shorter-dated bonds. Was the “sell-off”
                                                                                            60%
  amplified by the fact that buying shorter-dated BTPs has
                                                                                            40%
  been a “crowded-trade”?
                                                                                            20%
_ According to Tradeweb the ticket non-quote rate for the
                                                                                              0%
  entire Tradeweb market for Italian government bonds was
                                                                                           -20%
  47% (30th May 2018)                                                                              14            15                16           17              18             19
                                                                                           Source: Citigroup, as of January 2019

                                       Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or
Oliver Eichmann (DWS), February 2019                                                                                                                                                7
                                       analyses, which might prove inaccurate or incorrect
LIQUIDITY IN EURO AREA BOND MARKETS AND THE MARKET
IMPACT OF THE END OF NET PURCHASES OF THE APP
Topics to Discuss

_ What is a proper measure of market liquidity especially in times of market stress?
_ Will the change in market structure as a result of central bank purchases increase the risk of liquidity-shortfalls once the
  ESCB stops asset purchases (e.g. Euro covered bond market)?
_ If central bank asset purchase programs help to lower the liquidity premiums in the respective markets? Does this mean
  the end of central bank purchases will revert this completely? Or is there a persistent effect due to changes in the market
  structure and investor behavior?
_ Is there a change in the investor base in several market segments e.g. Euro corporate bonds as a result of the low yield
  environment and the ECB‘s forward guidance? If so, does this increase the risk of pro-cyclical behavior especially in
  times of stress?
_ How do participants see the electronic trading in the context of liquidity?

                                       Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or
Oliver Eichmann (DWS), February 2019                                                                                                                                               8
                                       analyses, which might prove inaccurate or incorrect
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Oliver Eichmann (DWS), February 2019                                                                                                                                   9
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