The EU is preparing to wade into increasingly choppy bond markets as it embarks on the European Commission’s biggest-ever borrowing programme.
Debt managers at the commission have held calls with banks and investors this week ahead of the sale of the first bond backing its €800bn NextGenerationEU recovery fund — the groundbreaking vehicle agreed last summer to fund the region’s pandemic response with debt backed jointly by member states.
Bankers are expecting the deal to price next week, raising more than €10bn from a new 10-year bond.
The sale is the latest milestone in the transformation of the EU itself into one of Europe’s biggest bond issuers, and a prelude to regular debt auctions starting in September as Brussels aims to raise €80bn for the recovery fund before the end of the year.
It comes at a time when markets have been buffeted by rising inflation, and investors are speculating about when the European Central Bank will begin to wind down its €1.85tn emergency bond-buying programme.
“They’re starting this process in a rising rate environment; it’s a different world to last year,” said Antoine Bouvet, a senior interest rates strategist at ING. “I don’t think anyone doubts the EU’s ability to sell this debt, but they’ll be paying out a bit more to do it.”
Brussels’ borrowing costs have risen since October when the first bond to fund the EU’s Sure programme — a smaller €100bn scheme to support jobs during the pandemic — met with record-breaking demand. Since then, the yield on 10-year EU bonds has risen 0.3 percentage points to just above zero, echoing similar advances across eurozone debt markets.
“Thanks to the EU’s high credit rating, the Commission will be able to borrow on advantageous conditions,” the European Commission said. “The Commission will then pass the benefit on to the EU Member States directly when providing them loans or to the Union budget in the form of low interest rate payments on borrowings to finance recovery spending.”
The ECB is widely expected to continue with €80bn a month of net bond purchases at its latest policy meeting on Thursday. Even so, the topic of a reduction in the pace of buying is likely to return later in the year as economies rebound from the pandemic.
Markets got a taste last month of what that might look like, as speculation of a reduction in support hit bond prices, pushing yields to their highest level in a year. During that period, the most recent EU debt sale drew weaker demand from investors than earlier issues. Yields have since fallen back, after ECB boss Christine Lagarde said it was “far too early” to discuss tapering.
Brussels has already made strides towards becoming an established force in bond markets. Prior to the launch of Sure, it had just €50bn in outstanding bonds, a figure dwarfed by the big national debt piles, like Germany at about €1.5tn, and Italy at €2.2tn. But since October the commission has raised €90bn of debt under Sure, in seven transactions.
The €80bn of NextGenerationEU debt the EU plans to issue in the second half of the year will make it the biggest net borrower in the euro area over that period. The commission aims to raise up to €800bn between now and the end of 2026 for the programme, with about €407bn available for grants to member states and €386bn for loans. Borrowing volumes will average €150bn a year. About 30 per cent of the bonds is ultimately expected to be earmarked as green bonds to bolster sustainable finance.
Alongside preparations for borrowing, the commission has in recent weeks been working through member states’ detailed recovery and resilience plans, in which they pitch for the EU funding and set out investments and reforms. These then need to be signed off by member states.
Trading of EU bonds in the secondary market has increased as much as 10 times since last summer, transforming a relatively sleepy backwater more akin to the debt of other supranational bodies such as the European Investment Bank or the European Stability Mechanism into a market to rival Italy or France, figures from bond trading platform Tradeweb show.
The EU’s bonds have recovered more slowly from the recent price drop than most eurozone debt, a sign that the coming deluge of issuance is weighing on prices, according to Michael Leister, head of interest rates strategy at Commerzbank. Uncertainty over the path of ECB policy would give investors “more bargaining power” to demand extra yield at sales of new debt, he added.
“We will buy [the new EU bonds], especially if they offer a decent premium over Germany,” said Paul Brain, head of fixed income at Newton Investment Management. “But the market has a lot of issuance to digest, not just joint issuance through the recovery fund but from individual governments.”
Thanks to its triple A credit rating, the EU still enjoys lower funding costs than the vast majority of member states, with the exception of Germany — the euro area’s ultimate market haven.
But any shift in the EU’s funding cost relative to member states could be significant, said Leister. States including France and Belgium, whose long-term funding costs were slightly above those of the EU, could be less inclined to take loans from the recovery fund if the gap narrowed.
Countries like Spain, meanwhile, could be more inclined to take up loans if their own borrowing premium rises faster than the EU’s. As things stand seven EU member states have requested loans under the programme, but the commission will remain open to loan requests up to August 2023.
“It boils down to the relative cost, and even a small market move changes that quite a lot when rates are this low everywhere,” Leister said.