The European Union should burnish its bonds for prime time

Time for the EU to burnish its bonds. (Source: Bloomberg/Getty Images Europe)

Now that the European Union has sold €513 billion ($550 billion) of debt, a stockpile poised to reach at least €800 billion by 2026, the bloc should
accelerate plans to qualify as a fully-fledged government bond market. Building a proper primary dealer network, augmented by repurchase facilities and futures contracts, would enhance liquidity, broaden demand from both euro zone and global investors and reduce borrowing costs for the bloc.

MSCI Inc and Intercontinental Exchange Inc have issued consultation papers seeking views on the viability of reclassifying EU Commission issues as sovereign debt rather than supranational bonds. That matters because the latter trade at wider dealing spreads akin to corporate debt, while the former have a broader worldwide investor audience. And while MSCI and ICE are second-tier providers of the fixed-income benchmarks against which portfolio managers gauge performance, such a move would set a precedent that more established index compilers including Citigroup Inc, Bank of America Corp. and Bloomberg LP would likely follow.

The EU had barely €50 billion of bonds outstanding before the pandemic hit; the sudden requirement for massive funding to underpin the economy led to a vast upscaling of borrowing by the commission. This kicked off with the SURE job support program in mid-2020, ramping up to the wider NextGen €800 billion program of loans and grants to member states — funded by mutualized debt sales.

Qualifying as government debt would bump EU bonds higher up the fixed-income hierarchy when investors are considering where to put money to work. And that wouldn’t just be an intra-euro area dynamic; Mohit Kumar, chief Europe economist at Jefferies Financial Group Inc, reckons that demand from Asian and Middle East sovereign wealth funds would increase.

The EU has AAA grades from the major credit-rating companies, yet trades at a modest yield premium to six euro nations — including France, which is rated two notches lower at AA by Standard & Poor’s Corp. So it’s easy to see how the momentum for lower borrowing costs for the bloc could build.

I laid out in October a list of requirements the EU needs to satisfy to be classified as a sovereign asset class, including a comprehensive primary dealer network, a repurchase market to increase liquidity and a futures contract to facilitate trading. Bunching its new issuance into larger individual bond deals would also help. So far, progress on these enhancements has been slow.

Recent comments from German Bundesbank President Joachim Nagel, throwing up the usual roadblocks for increasing centralized EU borrowing, suggest that machinations are afoot behind closed doors to expand its debt program. While the German constitutional court remains an impediment to mutualized debt, the NextGen program showed that it's not unsurpassable. A firm German “nein” could become “maybe” if some guard rails are put in place.

The EU debt stockpile risks becoming a stranded asset class, left to wither into runoff. Investors tend not to focus on temporary debt programs. That would be a waste. The bloc needs to support Ukraine, fortify European defenses and upscale its net zero climate-change initiatives — all existential requirements for the EU's ongoing survival and relevance. Over time, the political imperatives should outweigh the notable reluctance of the euro’s more frugal states to allow increased centralized borrowing.

The NextGen platform provides a perfect template, and it’s hard to un-invent such a creature. After the EU June elections, repurposing un-allocated commitments from the initial program with new monies and goals could be the bedrock of the next Commission's five-year term. As former European Central Bank Vice President Vitor Constancio tweeted on X last week, there are “crucial needs to fulfill. Let’s hope the `frugal ones’ understand that.”

It's long been part of the EU’s common currency project to cement monetary union with mutual debt sales. Its chance of achieving that might be getting closer now that bond index providers are ready to play ball — even before the supporting complementary parts that most sovereign bond markets require are fully in place. The secret sauce of the euro project has always been its adaptability in a crisis. The EU should make good use of the bloc’s lengthening list of financial needs to improve upon a half-built debt project rushed through during the pandemic.

Credit: Bloomberg