SUERF: The safe asset potential of EU-issued bonds
23 November 2022
Currently, one obstacle to EU bonds achieving a genuine euro-denominated safe asset status, approaching that of Bunds, lies in the one-off, time-limited nature of the EU’s Covid-19-related policy responses.
A safe asset is of high credit
quality, retains its value in bad times, and is traded in liquid
markets. We show that bonds issued by the European Union (EU) are widely
considered to be of high credit quality, and that their yield spread
over German Bunds remained contained during the 2020 Covid-19 pandemic
recession. Recent issuances and taps under the EU’s SURE and NGEU
initiatives helped improve EU bonds’ market liquidity from previously
low levels, also reducing liquidity risk premia. Eurosystem purchases
and holdings of EU bonds did not impair market liquidity.
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.
A new big player on Europe’s bond markets
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.
The need for euro-denominated safe assets
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.
EU bonds: creditworthy, robust, but also liquid enough?
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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