Can EU bonds rival the German bund?

The EU has become a major player in international debt markets as a steady issuer of safe assets — an advent that’s been seen as a watershed moment for the euro area, according to Goldman Sachs Research. But while the bloc has successfully scaled up as an issuer, EU bonds trail those of France and Germany’s bund in some respects despite the EU’s top AAA credit rating.

Compared to the U.S., the market for euro-denominated safe assets is relatively small and fragmented. That began to change as the union issued bonds to fund programs to help member states recover from the Covid pandemic. The European unemployment insurance scheme (the SURE program) started in 2020, and the Next Generation EU (or NGEU) recovery plan was put in place the following year.

The EU now has a debt stock of more than €400 billion ($450 billion), up from around €50 billion at the end of 2019, Goldman Sachs Research analyst Simon Freycenet writes in the team’s report. Its public debt stock is the fifth largest in the euro area.

The NGEU recovery plan resulted in the EU issuing debt across a series of benchmark maturities, which better resembles the strategies used by other major public entities and gives the market more transparent funding plans. “The issuance related to the NGEU from June 2021 onward was key in establishing the European Union as a regular presence in debt markets,” Freycenet writes.

EU bonds have a diverse investor base both in terms of institutional sectors and geographies, Freycenet writes. Investments funds and commercial banks were the key participants in syndications since October-2020. Meanwhile take-up by pensions and insurers, at 12% on average, appears low, as the elevated average maturity of EU debt (about 14 years) should have some appeal for these players. Central banks and official institutions represent a fifth of take-up, and this share has diminished only modestly since the end of the European Central Bank’s quantitative easing bond-buying program in June 2022.

Geographically, sponsorship appears to be broad, particularly in Europe. Take-up of non-European investors has regularly been under 5-10%, but it’s possible that American or Asian institutions purchased EU debt via U.K. entities, distorting the analysis of the geographic distribution.

“The above suggests the EU has succeeded in scaling up as an issuer,” Freycenet writes. Debt issuance operations have been oversubscribed by a factor of eight on average, even as supply shocks were also pushing up issuance needs across the area.

That said, EU bonds have generally underperformed other high-rated government securities. Although longer-dated EU bonds traded at lower yields than similar maturity French government bonds, EU debt consistently yielded more at shorter maturities (such as 5- to 10-year debentures) than debt issued by France (and at times Spain) — despite EU bonds having a higher credit ranking, according to Goldman Sachs Research.  When it comes to Germany, 10-year NGEU benchmark bonds trade more closely to KFW German agency debt, in terms of daily changes, rather than on par with German bunds, the euro area’s reference asset.

EU bonds could perform better versus higher-rated European government bonds in the coming quarters, Freycenet writes. Rates volatility and economic uncertainty is expected to decline as the ECB approaches the end of its hiking cycling, which could reduce the gap in yields between individual government bonds and debt of smaller markets. With disbursements on the horizon for the next three years, NGEU debt will continue to grow. Goldman Sachs Research estimates a total of €600 billion by the end of 2026.

Whether the market improves even more depends in part on the implementation of recovery fund investments (which have been slower than expected in Italy). Freycenet also points out that the NGEU is a temporary program. “This suggests to us that EU debt sponsorship will be in part conditioned on the assessment of whether the NGEU was a one-off answer to a specific situation or an important precedent (thus leading to possible EU debt issuance beyond 2026),” he writes.

“Taken together, while the investor base for EU debt continues to grow, this illustrates the difficulties in establishing a deep sponsorship without the reliance on a domestic/national financial system, especially over a short time frame,” he adds.