The European Bond Market - New Hegemon?
Government policy responses have been impressive in Europe. On top of national responses, several packages have been agreed at the EU level. In April, the Eurogroup put forward a EUR540bn emergency support package consisting of: a EUR240bn credit line from the European Stability Mechanism (ESM); a EUR100bn (loan-based) instrument to support short-time working arrangements (labelled ‘SURE’ for Support to mitigate Unemployment Risks in an Emergency); and a pan-European guarantee fund of EUR25bn from the European Investment Bank (EIB), which could support EUR200bn of financing for companies, with a focus on small- and medium-sized enterprises (SMEs).
In July, European leaders struck a deal on a Recovery Plan (labelled ‘Next Generation EU’ or NGEU) and on the 2021-2027 EU budget. The NGEU represents an important milestone for Europe, an historic step toward further fiscal integration and financial solidarity.
Combining the SURE unemployment insurance scheme and the Recovery Plan, the pool of bonds issued by the European Union (EU) could amount up to EUR900.6bn by 2024. EU bonds could share many of German government bonds’ ‘safe-haven’ asset characteristics: A high rating, liquidity, significant modified duration, and a negative correlation with risky assets.
First, the EU has been assigned the highest rating, AAA (by Moody’s, Fitch Ratings and DBRS), although the implied rating from EU bonds yields, as calculated by Moody’s, shows an average rating closer to Aa3, partly due to their lack of liquidity.
Second, as the amount outstanding increases, making its bonds much more liquid, we could see EU yields trading closer to their AAA-rated euro government peers, thanks to a compression of the ‘liquidity’ premium.
Third, the EU issues bonds with maturities ranging between 3 and 30 years. Although the European Commission (EC) has not yet published any details regarding upcoming auction maturities and amounts, the bulk of issuances will likely be concentrated in the long end. The EC has mentioned that it wants to give Member States enough time for their economies to recover fully before having to contribute more to the EU budget in order to reimburse the debt. As such, we expect the average modified duration of EU bonds to lie around seven years.
Last, the 9-year EU bond yield has a spread of 22 bps (on August 17) versus the German 10-year Bund yield. We expect this spread to diminish as outstanding amounts increase, so long-dated EU bond yields are likely also to be negatively correlated to risky assets, although German sovereign yields should remain the euro risk-free rate of reference. All in all, investors could deem EU bonds ‘safe-haven’ assets, meaning that they could grow the pool in euro.
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