ECB loosens collateral rules to accept ‘fallen angel’ bonds

The European Central Bank has changed its rules to accept “fallen angel” bonds that lose their investment-grade credit rating to maintain banks’ access to its ultra-cheap liquidity during the coronavirus crisis.

The move, which was approved by an unscheduled call of the ECB’s governing council on Wednesday, is designed to limit the financial turmoil that might otherwise be caused by an expected wave of credit rating downgrades in response to the pandemic.

About $275bn of non-financial corporate bonds could become fallen angels by being downgraded below the triple-B level minimum required for investment grade status within the next year, the OECD estimated in February.

The ECB has already granted a waiver for Greek sovereign bonds from its ban on accepting assets as collateral that have a credit rating below investment grade as part of a broad loosening of its collateral rules it announced two weeks ago.

On Wednesday, the ECB said it had decided to also temporarily exempt any bonds that are downgraded to junk status from its requirement that any collateral it accepts has an investment grade rating. Its loosened collateral rules will remain until September 2021.

It said it was prepared to go further if required to avert a eurozone debt crisis. “The ECB may decide, if and when necessary, to take additional measures to further mitigate the impact of rating downgrades, particularly with a view to ensuring the smooth transmission of its monetary policy in all jurisdictions of the euro area,” it said.

Alberto Gallo, portfolio manager at hedge fund Algebris Investments, said: “The ECB is acting to limit the procyclical action of rating agencies, and to shield sovereigns such as Italy from a downgrade. High-yield firms and SMEs are a large part of the real economy. It’s important that help doesn’t only go to large firms.”

Investors are particularly concerned by a potential downgrade of Italy’s sovereign debt ratings, with Standard & Poor’s set to announce a decision about that on Friday. Italy’s already weak economy has been one of the hardest hit by the coronavirus crisis, triggering fears that its high debt levels could become unsustainable.

Yields on Italian 10-year sovereign debt whipsawed on Wednesday ahead of the ECB’s unscheduled announcement, rising as high as 2.27 per cent before sliding to 2.08 per cent.

However, ECB officials said its decision to accept fallen angel bonds as collateral was more aimed at corporate bonds. Any downgrade of Italian sovereign debt to junk status could be dealt with using a similar waiver to the one granted to Greek bonds, they said.

UBS underlined the scale of the potential fallen angel problem by pointing out recently that since 2011, European bonds rated triple-B minus, one notch above junk status, had “ballooned” from €330bn to €1.14tn. Yet double-B rated junk bond issuance in the high-yield market has risen from €74bn to €185bn in that time.

The US Federal Reserve has gone further by including junk bonds in its asset-purchase programme and Wednesday’s decision by the ECB prompted speculation that it may follow suit as early as next week when its council meets to discuss monetary policy.

“You are having corporations in the high-yield space borrow at elevated levels at this point,” said Mona Mahajan, an investment strategist with Allianz Global Investors. “Both the ECB and Fed are looking to make sure the high-yield markets and credit markets generally stay liquid and functioning.”

Bob Michele, chief investment officer and head of global fixed income at JPMorgan Asset Management, said: “The ECB is pretty much telegraphing to the EU if you ramp up spending packages we are in a position to ramp up our purchase to help control the funding of that package.”

The ECB said it had “decided to grandfather the eligibility of marketable assets and the issuers of such assets that fulfilled minimum credit-quality requirements on 7 April 2020 in the event of a deterioration in credit ratings decided by the credit rating agencies accepted in the Eurosystem as long as the ratings remain above a certain credit quality level”. 

It means that any bonds rated at investment grade on April 7 will continue to be eligible even if they are downgraded below the triple-B level by the main credit rating agencies as long as their rating remains no more than two notches below investment grade.

Asset-backed securities with a rating of at least A-minus will be grandfathered in the ECB’s collateral regime as long as their rating remains at or above double-B plus. Fallen angel assets will be subjected to “haircuts” to reduce their value as collateral based on their latest credit rating.

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