1. Why is this a big deal?
Regionally backed debt issuance is about to explode. Under its four-year funding program, the EU’s 69 billion euros of outstanding bonds could increase by a factor of 15 or more. EU-wide securities have the potential to usurp German government bunds as the backbone of the euro area’s credit market and mirror the role played by Treasuries in the dollar debt market. The euro’s standing as a major currency could be boosted, since the mechanisms required to issue joint debt would alleviate longstanding concerns over the bloc’s structural risks and political divides. For some EU countries, a jointly issued asset underwritten by all members may break the so-called doom loop by lowering banks’ exposure to and reliance on debt issued by their own country.
2. What is a ‘safe asset’ and why is it important?
A safe asset is a security that acts as a benchmark for pricing all bonds in a particular currency. Investors demand a premium, or spread, to hold other more risky debt. Safe assets tend to rise when markets slump, because in times of turmoil people turn to investments they are confident will endure. A safe asset must be highly liquid and available in a wide range of maturities. Previous ideas for creating a Europe safe asset foundered over questions about how to divide up region-wide borrowings between countries of differing size and economic strength.
3. What advantages would this bring?
More stability and standardization in Europe’s markets, since member countries would be able to price bonds against one measure instead of a variety. Germany currently prices sovereign notes against bunds, Italy and Spain use their own bonds, while smaller countries and corporate bond issuers use mid-swaps, a market-derived interest rate. More broadly, the EU’s aim of creating a true and deep capital union will only be successful if regional markets become less fragmented. A safe asset would represent a major step toward that goal.
4. Would there be demand?
Plenty, judging by the first bond sale for the emergency jobs program in October 2020. The offering of social bonds drew more than 233 billion euros of orders, likely to be the biggest ever for any debt deal. The bloc’s 17 billion euro sale was nearly 14 times subscribed. Helping to boost demand for EU securities: the European Central Bank is able to buy up to 50% of the bloc’s issuance, more than for national markets, providing a guaranteed backstop.
5. What’s wrong with German bunds?
German state debt is certainly safe (it’s rated AAA by the major ratings providers) but there isn’t enough of it. Italy, France and Spain all issue more bonds than Germany. Bunds are also expensive; yields on a benchmark 10-year note are at around -0.3%, meaning that investors intending to hold the bonds to maturity are likely to make a loss. Yields on French bonds, which are seen as the best comparison to EU debt, are at around 0%. Furthermore, bunds are, by their very nature, underwritten by a single country, while a pan-EU safe asset would be backed by all 27 member states.
6. What would happen to borrowing costs?
For countries with lower credit ratings, costs could fall significantly, providing a shot in the arm to their economies. Debt currently issued by heavily indebted countries such as Italy trades at a steep premium associated with their credit risk. That premium is transmitted to banks who then pass it on to companies requiring loans. Banks would be able to use EU-backed assets as collateral, allowing them to lend to businesses at lower rates. A safe asset may bring down the cost of issuing sovereign bonds, too. October’s social bonds were priced at 36.7 basis points over bunds, giving an indication of how much sovereign debt issuers such as Italy would be able to save.
7. Is this good news for investors?
A haven of stability would be welcome during bouts of volatility, while ample liquidity would provide the flexibility to adjust portfolios and diversify. There is also the fact that defaults would be highly improbable, although stresses within the EU and its single currency cannot be ruled out. On the other hand, a risk-free asset could encourage exuberance and inflate market bubbles. And by narrowing spreads in the region, investment could be crowded out as money shies away from European debt and chases higher yields elsewhere. There’s also concern that it could compete with sovereign debt in the region.
8. What might hinder a European safe asset?
There’s always a chance the EU will go back to its previous position when the four-year plan elapses, meaning the volume of securities would be insufficient to achieve safe-asset status. And while the EU is rated AAA by Moody’s and Fitch, S&P has it only at AA. Goldman Sachs Group Inc. strategists have argued that EU safe asset bonds wouldn’t match the “insurance value” offered by bunds against extreme risk prospects, such as a breakup of the euro area, so they would trade at similar levels to French government debt. Critics say any new pan-EU bonds risk being seen as a “dressing-up” exercise, designed to shield stronger sovereign debt from the negative effects of potential defaults in peripheral countries. Then there’s political division within the bloc: All 27 national parliaments must sign off the pandemic rescue fund. Poland said it would use its veto if the bloc continued to infringe on its sovereignty. There’s also a court case in Germany that might hold things up.
9. What happens if and when countries approve the fund?
The EU needs to sell debt — and fast. The aim is to begin in June, via a process known as a syndication, and to auction bonds for the first time from September using a platform to connect with a network of primary bank dealers. The target is 150-200 billion euros per year of new issuance until 2026, with a yield curve extending to 30 years. The EU also wants to issue very short-dated debt called bills to raise money quickly.
10. How green will this be?
Almost a third of the recovery fund — as much as 250 billion euros — will be comprised of green bonds, designated solely for the financing of environmentally friendly projects. Through its sheer magnitude, that will make the EU the world leader in ESG debt. Still, the bloc needs to iron out its green bond standard, which it hopes will become a global benchmark — no mean feat given that member states such as Poland still heavily rely on fossil fuels.