Tuesday 09 August 2016 by Opinion

BoE surpises with corporate bond purchases and cuts rate

On Thursday 4 August 2016, the Bank of England (BoE) cut the Bank Rate by 25bp to a new record low 0.25%

Bank of England

See the chart below for more information.

UK interest rates since 1694

Source: Bank of England

This was priced in by the markets and 50 out of 52 economists in a Bloomberg survey also expected the cut.  However, the BoE’s Monetary Policy Committee (MPC) went further and essentially added a GBP170bn to its existing Quantitative Easing (QE) program.  This included a GBP100bn Term Funding Scheme (TFS) that will provide banks with low cost funding. 

On this the MPC stated:

“This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions. In addition, the TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.”

The BoE also increased its asset purchase scheme by GBP70bn to GBP435bn – GBP60bn of gilts and GBP10bn of corporate bonds.  Starting in mid-September, the gilts and corporate bonds will purchase over the next six months and 18 months, respectively. 

It is worth noting that all nine members of the MPC supported the interest rate cut and the TFS.  Eight members supported the introduction of a corporate bond scheme, and six members supported further purchases of UK government bonds.

Corporate Bond Purchase Scheme

Of particular interest was the BoE’s decision to buy corporate bonds through the Corporate Bond Purchase Scheme (CBPS).  The purpose of the CBPS is to drive monetary stimulus by lowering the yields on corporate bonds, thereby reducing the cost of borrowing for companies.

The CBPS will build a portfolio of up to GBP10bn of sterling bonds that are representative of issuance by firms making a material contribution to the UK economy, in order to impart broad economic stimulus.

Eligible securities will have the following characteristics:

  1. conventional senior, unsubordinated debt;
  2. bonds rated investment grade by at least one major rating agency and subject to the Bank’s assessment process;
  3. cleared and settled through Euroclear and/or Clearstream;
  4. minimum amount in issue of GBP100m;
  5. minimum residual maturity of twelve months; no perpetual debt; and
  6. at least one month since the security was issued.

Corporate bonds issued by banks, building societies and insurance companies will not be eligible.

The BoE will participate in the secondary market by holding reverse auctions but it reserves the right to carry out secondary market purchases via other methods, such as bilateral purchases, should it be deemed necessary.

Will UK base rates go lower?

Given the BoE revised down its growth forecasts for 2017 and 2018 to 0.8% (from 2.3%) and 1.8% (from 2.3%), respectively, it is highly likely that the UK will get lower rates.

In the question and answer session, the BoE Governor, Mark Carney was keen to emphasise that there was further room to cut rates but these would not go negative. Carney said, “The MPC is very clear that we see the effective lower bound as a positive number, close to zero, but a positive number […] I’m not a fan of negative interest rates.”

The consequences…

I think the main winners will be sterling denominated corporate bonds that should see yields compress further as the BoE enters into the market to acquire up to GBP10bn of eligible bonds – we have already seen these contract by up to 50bps.  The housing and construction sector should also benefit as banks will be able to provide attractively priced capital for home buyers.

Although the banks will not benefit from the CBPS, the sector will now have access to low cost funding through the TFS.

On the flipside, sterling will remain under pressure. Furthermore, savers and pensioners trying to generate an income will be hit as yields continue to be squeezed lower.