Modern financial systems rely on safe assets that are characterized by three aspects: quality, robustness, and liquidity. When compared to the United States, the market for euro-denominated safe assets is not only small, but also fragmented across different sub-markets. In light of this shortage and fragmentation, Bletzinger, Greif and Schwaab (2022) study the quickly growing market of EU-issued bonds, with a view to assessing their prospects for ultimately becoming a genuine euro-denominated safe asset.

 

The implementation of SURE and NGEU in 2020 and 2021 marked a watershed in the landscape of the EU’s common fiscal policy, both regarding the sizable volumes and the independent funding structures. Historically, EU borrowing has taken place since the early 1980s and typically lent to beneficiary countries in a back-to-back fashion, meaning that countries’ loan repayments to the EU were matched one for one with the EU’s own coupon and principal payments. The much larger SURE and NGEU-related volumes have required a more active liquidity management of the EU’s balance sheet. In April 2021, the practice of back-to-back lending was therefore not made a requirement for the NGEU initiative, giving instead way to a more flexible management of EU funds.

 

As of December 2021, the amount of outstanding EU bonds has grown to €215 billion (bn) in total. The first SURE bonds were issued in October 2020, while the first NGEU bonds were issued in June 2021. By December 2021, SURE and NGEU-related bonds account for three-quarters of all outstanding debt. By 2028, NGEU volumes are foreseen to reach €800 bn, more than twelve times the December 2021 volume. Together with the approved funding for other smaller programs, the total available amount of EU bonds is scheduled to exceed €1 trillion by 2028. This amount corresponds to approximately 43% of Germany’s public debt in 2020, and to approximately 65% of Spain’s.

 

Safe assets are characterized by three aspects (see Bletzinger et al. (2022) for relevant literature): First, a low default risk, or high asset “quality”. Second, like a good friend, a safe asset retains its value during bad times (“robustness”).  Third, a safe asset can be sold at or near current (robust) market prices in most market conditions (“liquidity”).

 

There is widespread agreement among policy makers that the euro area suffers from a relative lack of euro-denominated safe assets, particularly when compared to the United States. In addition, the market for sovereign bonds in the EU is fragmented across different sub-markets, and market participants’ perceptions about the relative risks of these sub-markets can change over time. The lack and fragmentation of euro-denominated safe assets are unfortunate, since both can increase the risk of vicious bank-sovereign “doom loops,” of high public borrowing costs in bad times, and of unwelcome flights-to-safety that increase financial fragmentation.

 

In bond markets, investors demand additional compensation relative to the safest assets for a range of risks, with default risk (i.e. the risk that the issuer does not repay its obligations) often being the most important. Several institutional layers of debt-service protection render EU-issued bonds, including SURE and NGEU-related bonds, low in default risk. Rating agencies, however, are not in complete agreement on the extent to which EU bonds are entirely free of default risk. Moody’s keeps its best long-term issuer rating (Aaa) for the EU while Standard and Poor’s only provides a long-term issuer rating from its second-best rating bracket (AA), two notches below its top rating. The horizontal axis of Figure 1 plots the minimal rating across four rating agencies on its horizontal axis, suggesting that rating agencies collectively consider EU bonds’ credit quality as close but not (yet) equal to those of e.g. German Bunds. At the same time, EU bonds have traded at tight yield spreads to German Bunds, and below 2019 GDP-weighted average euro area yields, suggesting that the high credit quality of EU bonds is well-understood by market participants. ...

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