Game changer? How $858 bn Covid-19 recovery fund will shake up EU bond mkts

The European Union is about to vault into the ranks of the world's biggest supranational issuers after it gave the green light to a recovery fund financed via joint debt, a move that carries the potential to shake up euro debt markets.

EU leaders have agreed a deal on a 750 billion euro ($858 billion) fund to address Covid-19 damage; together with its seven-year budget, that unlocks a total 1.8 trillion euro spending boost.

Until now, the EU as an institution has contributed a fraction of the bloc's roughly 8.5 trillion euro market of government and agency bonds. But the money it's about to start raising could push its debt levels above that of member states such as Netherlands.

"For the first time, the European Union will be a major force on sovereign debt markets," said Berenberg chief economist Holger Schmieding.

 

1. Super Spender

The EU currently has around 54 billion euros in outstanding debt, having borrowed nothing last year and just 5 billion euros in 2018.

But if the entire 750 billion euros is raised on bond markets, issuance could amount to 262.5 billion euros next year and in 2022, with the remaining 225 billion euros coming in 2023, ING senior rates strategist Antoine Bouvet estimates.

In comparison, gross annual issuance from the European Investment Bank, EU, European Financial Stability Facility and European Stability Mechanism averaged 67 billion euros per year in 2015-19.

The International Bank for Reconstruction and Development has roughly $201 billion of outstanding debt.

The EU also will borrow nearly 100 billion euros starting in September to fund its SURE unemployment scheme.

But the issuance won't significantly reduce bond supply from highly indebted states such as Italy just yet, given it will be spread out over some years.

2. AAA Asset

Financing the fund with joint EU bonds marks a big step towards mutualising member states' debt.

"Such common liabilities for the European Union are unprecedented in size," said Sebastien Galy, senior macro strategist at Nordea Asset Management.

It will also address one of the euro's drawbacks for reserve managers: the lack of a big pool of "safe" assets, comparable with U.S. Treasury bonds - a triple-A rated market worth over $17 trillion.

German, French and Italian bond markets combined are less than half that size, and only Germany carries the AAA score.

The EU however, has a triple-A rating from Moody's, Fitch, DBRS and Scope. S&P Global rates it AA. Agencies suggest the upcoming debt surge is not yet a threat to the ratings.

3. Green Boost

With the EU Commission planning to target 30% of the fund to climate projects, a third of the recovery fund could be financed via green bonds, S&P Global predicts. That would boost the size of the global green bond market by 89%.

Green bonds currently comprise just 3.7% of global issuance.

"At a time where markets are looking for safe borrowers, this should be an example for other supranational institutions (like the World Bank) to finance badly needed investments, in particular to fight global warming," said Florence Pisani, global head of economic research at Candriam.

4. ECB Relief

The European Central Bank will also get an opportunity to ramp up purchases of supranational debt for its stimulus programme.

The first few months of the ECB's emergency bond-buying scheme launched in March saw it buy a smaller share of supra debt than usual, BNP Paribas noted, but the bank expects up to 96 billion euros worth of fresh supra supply in coming months.

It expects the share of PEPP purchases of public bonds allocated to supranational debt could rise to at least 10% in the second half of 2020 from 7.5% now.