FT columnist Wolfgang Münchau raises the idea of a single European bond in today’s FT.
The article poses some solid food for thought. Münchau points out that while it is widening sovereign bond spreads across various eurozone members that may have provided a relatively ‘bad’ pretext for the discussion, it is nevertheless a good idea to address the concept.
For one, Münchau argues a single European bond could create a potential rival to that of the US Treasury market, bringing about substantial financial and economic benefits to Europe. In a time of mass issuance, after all, anything that helps you stand out from the crowd can help attract investment.
Despite the potential benefits Germany is the eurozone member most likely to object contends Münchau. As he explains:
The idea was predictably knocked down by the German finance minister, who quickly calculated that a joint European bond would cost Germany extra annual funding costs of €3bn ($3.9bn, £2.8bn) a year. I do not know how he arrived at the figure because the actual cost depends greatly on how such a common bond would be constructed. In any case, if Germany was a loser, there would be a simple solution to the problem: let every loser be compensated by the winners. The financial and potentially economic benefits would be larger than the compensation.
So, as Münchau points out, it is all about how the bond is structured – the ultimate aim being protecting the bond’s overall triple-A rating. More importantly, merging Germany’s triple A bonds with the lower rate bonds of Greece, Italy, Portugal and Spain would not necessarily have to result in an average pricing of all the debt (eg. be a cost to Germany).
Münchau refers to a recent discussion paper on the matter penned by the European Primary Dealers Association, looking at the likely benefits and practical implementation of a common European bond. To address the issue the paper looked at six theoretical models (based on shared assumptions including political will) in which a European bond could be brought to market. It asked dealers to analyse the pricing potential in each case.
The six options were:
- A bond issued by all 15 euro area sovereign issuers and comprising their total annual debt issuance
- A bond issued by all 15 euro area sovereign issuers, comprising their total annual debt issuance, and with a “guarantee fund” administered by the issuing agency
- A bond issued by all 15 euro area sovereign issuers comprising 50 per cent of each issuer’s total annual debt issuance and with a “guarantee fund” administered by the issuing agency. Sovereign issuers would issue in their own name the remainder of their annual volumes
- A bond issued by the 12 small and medium size euro area sovereign issuers (ie, excluding France, Germany and Italy) and comprising their total annual debt issuance
- A bond issued by AAA-rated euro area sovereign issuers excluding France and Germany and comprising their total annual debt issuance
- A 6 month Treasury Bill issued by all 15 euro area sovereign issuers, comprising their total annual issuance for Bills of less than one year maturity
The supposed benefits of a common European bond either way according to the paper were as follows:
It is contended that the prospect of common issuance creates scope for much larger volume issues and could reduce the costs of borrowing for Member States, with greatest advantage for smaller and medium sized issuers. A common European government bond would better enable Europe to compete with the US Treasury market as the most liquid market globally and could aid the development of the euro as a reserve currency.
For dealers, a consolidation through one euro issuer of euro sovereign bond issuance would likely remove the need for national Debt Management Offices to enforce market making obligations on Primary Dealers which is a large cost for those that participate in the market.
…it would enable a euro area-wide futures contract based on the underlying common bond rather
than one based on a single sovereign issuer as at present. A common European government bond would also create possibilities for a larger and more liquid repo market enabling dealers to take short positions more easily and enhancing liquidity in the cash market. The cash, repo and futures market could work in a virtuous circle each enhancing the others’ liquidity which would then lower the cost of borrowing in the first instance.
A commonly issued European government bond would better enable Europe to compete with the US Treasury market as the most liquid market globally. Indeed the European Commission’s recent paper noted that “fragmentation in supply has meant that the euro-denominated government bond market cannot compete with the corresponding US and Japanese markets in terms of liquidity.
Overall, simply merging every member’s old and new debt into a single eurozone bond without any further supporting arrangements was not seen as the best answer.
One answer, incorporated into three options, as Münchau explains, was the creation of a fund to guarantee coupon payments, into which member states would pay according to some agreed criteria. This was also the favoured route of the credit agencies, consulted because of the integral role ratings would play in any model. Their conclusions were (our emphasis):
Factors singled out by credit ratings agencies as relevant to a credit rating assessment include:
• the existence of an enforceable legal obligation on participating Member States in order to ensure that common debt is senior to any debt that is issued in their own name following the introduction of common issuance;
• the existence of an issuing entity that is free from political interference;
• that all issuers are liable for a proportionate share of each maturity;
• and, where participating issuers carry different credit ratings, the existence of a liquidity cushion or “guarantee fund” to ensure sufficient liquidity to meet upcoming bond redemption payments.
But with a guarantee-fund model we enter the shady environment of structured products and securitisation – ever a worry in the current post subprime securitisation disaster world.
According to the survey, dealers warned investors would not only need to be comfortable with the product before any of the perceived benefits materialised, a “Guarantee Fund” model would indeed be viewed as a structured product for which they stressed current investor appetite was poor – not to say this would not eventually change.
However, on the Guaranteed Fund model they specifically noted the following:
The “Guarantee Fund” would need to be defined in greater detail and be viewed as free from political influence for the market to price these common bonds more aggressively.
And accordingly (our emphasis):
From a pricing point of view, the mechanism of senior (common) debt and subordinated (national) debt was much preferred to a “guarantee fund” if a simple mechanism could be developed which could prevent issuers offloading risk into the common structure. In other words, the senior debt would need a simple structure to ensure it retained a AAA rating with the percentage of debt permitted therein for non-AAA issuers capped accordingly. However subordinated debt would carry a credit premium and be priced accordingly in market.
So in dealers’ eyes options V and VI shared the advantages of being the simplest and most palatable options – an obvious mismatch with the ratings agencies. Dealers overall doubts about ever bringing such a product to market were, however, also duly noted and seen as possibly impacting their pricing preferences.
Nevertheless Münchau also concurs that option 6 (the T-bill style shorter security) would indeed likely be easiest option to implement. As he explains:
A bond is a long-term finance instrument with a fixed coupon, paid in regular intervals. A bill, by contrast, has a much shorter duration, normally a year, or less, and it is a discounted security. This means you buy a bill at a discounted price and it is repaid at par value on expiry.
The treasury bill market is huge in the US, much larger than in the eurozone, which is more reliant on traditional bonds. But the creation of a common bills market could be a good start. It is not nearly as controversial politically and European governments may even start to shift from bonds into bills over time. Once this experiment is deemed to have worked, you could merge the bond markets in a second step.
Of course there is consensus that whatever route was taken, it would be no instant solution to the current discrepancies facing the pricing of European sovereign bonds.
Related links:
A common European government bond – EPDA discussion paper
The benefits of a single European bond – FT.com
