Winston Churchill is generally attributed with first saying, “You should never let a good crisis go to waste,” at the Yalta Conference in 1945. The European Union has taken the words of the war time British Prime Minister to heart. It seems to need intermittent existential crises to galvanize essential reform.
The latest example is the funding of the Next Generation EU (NGEU) budget, aimed at supporting economic recovery in those states most severely impacted by the COVID-19 pandemic. The EU Commission will raise up to €800 billion, roughly €150 billion annually, by the end of 2026. The inaugural NGEU bond came to market on June 15, 2021. It was the largest ever single-tranche issue in Europe, €20 billion in 10-Year bonds, with the biggest ever book (€142 billion in total demand).
To put that into perspective, the Commission has been active in bond markets for a decade. In 2010, the European Financial Stabilisation Mechanism (EFSM) was announced, effectively a bailout fund for states teetering on the brink of economic disaster or leaving the Union. A total of €46.8 billion was disbursed to Ireland and Portugal between 2011 and 2014 at the height of the Eurozone crisis.
A Giant Fiscal Leap Forward
The initial response to COVID-19 came in the form of SURE (Support to Mitigate Unemployment Risks in an Emergency) bonds, which raised €90 billion in seven transactions between October 2020 and May 2021. The program is capped at €100 billion. These have been baby steps toward a fiscal union; NGEU bonds are a giant leap forward.
The sheer size of NGEU bonds sets them apart. But so does the scope and mechanics of their issuance. For the first time, the Commission has issued bills with maturities of 12 months or less. It is doing so via regular auctions with a pre-determined schedule using the Telsat system operated by the Banque de France and used by Agence France Trésor.
The initial target is for €10 billion of bill issuance in 2021. The first bills, with three- and six-month maturities, came to market Sept. 15, 2021. Following the auction, the EU bills were listed on the Luxembourg Stock Exchange for secondary trading. Since then, there have been two auctions each month.
There is a 29-strong primary-dealer network. Now other venues have begun to offer secondary markets in both EU bonds and bills. BrokerTec launched a market-making program on Nov. 1. Banks in the program have similar obligations to primary dealers. Participants are required to offer quotes for four hours each day in a minimum size of €5 million. To incentivize new dealers, BrokerTec will offer rebates.
It is widely expected that futures markets will also be launched. In terms of outstanding issuance, EU Next Gen bonds are an equivalent market size to Spanish government bonds. Derivatives are likely to increase liquidity by providing investors with hedging options.
With NGEU issuance the Commission has gone a long way toward emulating the structure of sovereign debt. If the stock of bills reaches the €60 billion anticipated, that will equate to 8% of the maximum amount of EU debt, a figure in line with other sovereigns. The Commission has far more flexibility to choose the maturity of this new issuance as long as it does not exceed a 17-year average.
Close to a Sovereign Bond
The Commission also remains a supranational issuer without a common budget and tax raising powers. EU states are not jointly and severally liable for NGEU issuance and the Commission in its initial press release went out of its way to stress this was a “temporary recovery instrument.”
However, NGEU bonds are far closer to sovereigns than any other previous EU issuance and the aftermath of the Global Financial Crisis showed that “temporary” measures agreed in response to emergencies can quickly morph into permanent necessities. The mood music in Europe is undoubtedly changing as monetary hawks, such as the Bundesbank’s long-serving president Jens Weidmann, reach retirement or step down.
The NGEU program has put the infrastructure in place to expedite far greater borrowing and is the first time the currency bloc has issued bonds at scale. NGEU bonds will not replace German Bunds as Europe’s de facto “safe asset” for some time. The Bund market has €1.5 trillion outstanding, close to double the size of NGEU issuance expected by 2026.
NGEU and Bunds combined remain barely one-tenth of the size of the U.S. Treasury market.
Given the demand for NGEU bonds, Bank of America Securities expects spreads over Bunds to tighten to close to Dutch bonds. The first issue was at 32.3 basis points (bps) over the equivalent 0.00% Bund due 02/ 2031. Italy and Spain look likely to be the biggest beneficiaries in terms of spread tightening versus Bunds.
NGEU bonds are likely to prove a historic step toward greater EU integration. NGEU green bonds are more significant still. They are a game changer. The Commission has decided that at least one-third of its new bonds will come carrying the green label. Currently only 0.2% of OECD government debt outstanding is “green” though this has been growing at a rapid clip.
The EU is on course to be the biggest issuer of green bonds and clearly wanted to make a statement with its first issue. It was priced at a yield of 0.453%, a lower new issue premium than vanilla NGEU bonds. EU budget commissioner Johannes Hahn estimates a “greenium” (green bond premium) of 2.5 basis points.
On Sept. 2, 2020, the German Finance Agency offered €6.5 billion of green Bunds with the same coupon and maturity as non-green Bunds sold just one week before. The Green Bund was initially priced at one basis point lower but has traded as much as seven basis points lower. This may reflect relative scarcity as fund managers look to green their bond portfolios.
It is also a product of underlying demand from an increasingly green-conscious client base among both institutional and retail investors. The size of the EU’s commitment to green bonds raises an interesting prospect. NGEU issuance overall is as big as Spain’s, which supports futures. Issuing bills means there is also a meaningful euro yield curve from three-months to 30-years.
A new, green force is active in the global bond markets – one which is impossible for investors to ignore.
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