Risk and finance professionals convened for a Risk.net webinar in association with Eurex to discuss the impact of the European Union’s groundbreaking Support to mitigate Unemployment Risks in an Emergency – known as Sure – Next Generation EU bond issuances on the derivatives market and factors influencing rollout of associated products
- Moderator: Lee Bartholomew, Head of Fixed Income Product Research and Development (R&D), Eurex
- Jutta Frey-Hartenberger, Fixed Income Product R&D, Eurex
- Natacha Hilger, Relationship Manager, European Debt Management Offices, Deutsche Bank
- Jovita Razauskaite, Portfolio Manager, Green Bonds, NN Investment Partners
The European Union is set to become the largest supranational bond issuer in Europe thanks to two ambitious programmes that are likely to have repercussions throughout global capital markets.
The €100 billion Support to mitigate Unemployment Risks in an Emergency (Sure) programme is a temporary scheme to provide loans to member states to finance labour markets impacted by Covid-19, while Next Generation EU (NGEU) is a €750 billion recovery fund, 30% of which is allocated to green investments.
Lee Bartholomew, head of fixed income product research and development (R&D) at Eurex, described the schemes as “a significant event for European capital markets, highlighting progress since the introduction of the euro”.
The programmes will have a “massive supply impact” on European bond markets, said Natacha Hilger, a relationship manager in European debt management at Deutsche Bank. The NGEU programme makes up 5.5% of EU GDP, so it could hugely aid economic recovery, impact the issuance programmes of EU nationals and improve sovereign credit ratings, she added.
Moderated by Bartholomew and hosted by Risk.net in February 2021, webinar panellists discussed the implications of the EU bond issuance on European capital markets and whether new listed and exchange-traded derivatives will be required.
Deutsche Bank’s Hilger estimated that, in 2021 under the NGEU programme, the EU may issue €10 billion in new bonds every two weeks, putting it in the same league as huge players such as Spain and France.
As well as the impact on supply, she sees it affecting derivatives. “We see a lot of swaps trading correlated to the new Sure issuance,” she said. The successful performance of these bonds and the tightening of spreads has impacted positively across the wider EU supranational, sovereign and agency bond markets..
But the biggest impact could be on the EU recovery, she said, offering the example of Italy, which could receive more than €200 billion from the EU – approximately 12% of its GDP.
Additionally, depending on the pace of disbursement of NGEU funding, Hilger also expected an impact on the national euro government bond (EGB) issuance programme in the second half of the year. The NGEU programme could even improve sovereign credit ratings by enabling some countries to reduce their gross funding financing needs.
While the Covid‑19 pandemic afforded a huge stress test for international capital markets, a positive outcome was that it broke down the decades-long resistance to European bonds, said Jutta Frey-Hartenberger, fixed income product R&D at Eurex. “[The pandemic] finally allowed for the agreement within the EU to jointly issue EU bonds at decent size with some hope that this is also the first step towards fiscal integration in Europe,” she said.
She agreed with Hilger that the size of this AAA rated debt issuance would certainly alter the landscape of the European capital market, something seen in January when national treasuries were very active on issuing.
However, she points out there are still some unknowns. The EU borrowings are guaranteed by EU member states through the EU budget, which is now confirmed to the end of 2027, but the repayment of NGEU bonds from 2028 to 2058 will require a future EU budget, which needs the approval of EU member states. “This is considered a certain risk and probably a disadvantage compared to the individual member states’ budgets, with their solid funding and tax structures,” she said.
Frey-Hartenberger also stressed the need for a “more regular issuance schedule with probably an auction model” to increase investor confidence and gain international investors. Developing the methodologies and mechanisms for this EU bond issuance is another important aspect of the EU bond programme, and could enable further joint EU funding projects in the future, she said.
Hilger sees the EU bond issuance “as competitive as the big liquid EGB markets”, such as France and Germany, but noted that the outstanding value on the bonds in these countries is much greater and they have well-established markets with liquid futures and a wide range of products.
Currently, the EU bonds trade closer to Austria and Finland EGBs, and they are priced against swaps. “There are not a lot of EGB switches for investors buying EU bonds at the moment. It’s more that they have taken up this new issuance outright.” This has reduced the impact on spreads, she said.
“Because the EU bonds have tightened so rapidly versus swaps we have seen even more buying on OAT [French Treasury bonds] long term because the steeper curve of OAT is more attractive to investors than the flatter curve of the EU bonds.” The credit strength of the EU bonds means there has been as much foreign investment interest in EU bonds as in OAT, Hilger notes. “We think NGEU will attract as many investors, even if it will not have the social framework behind it.”
An important aspect of the NGEU issuance is that it will allow a ‘green’ reference curve to be built, believes Jovita Razauskaite, green bonds portfolio manager at NN Investment Partners.
“In the green market we … do not have any kind of green reference curve. With the €225 billion issuance from the EU at different maturities, we can definitely see the green reference curve building itself here,” she said.
She also expects the European Green Deal – which sets out a road map for the European ambition to cut emissions by 55% by 2030, and to be carbon neutral by 2050 – to encourage more investors into the green bond space. This would require full industry mobilisation.
The bond issuance could even set new standards, she said, with the European Commission (EC) having to ensure proceeds are allocated to green projects with a positive and measurable environmental impact. Issuers will need to gather data and provide quality reporting in line with the European taxonomy to minimise the risk of greenwashing, she said.
“A game-changer here would be alignment to the EU taxonomy because the standard will strengthen the EU classification system for sustainability activities and standards of practice,” Razauskaite added.
Tenor and frequency
The tenors of the NGEU offerings are likely to follow the liquidity points already established by the €53.5 billion of Sure bonds already issued, said Hilger. She sees the need for a short bond – two or three years – an intermediary tenor of five to seven years and a 10-year tenor, which she described as “essential”. She also believes 15-, 20- and 30-year tenors will be required.
The minimum size can then vary between the maturities, she said, adding that, if the NGEU programme needs to make rapid disbursements, the EU could issue Treasury bills, which are an easy product for raising funds rapidly.
Frey-Hartenberger stressed the importance of establishing liquidity in the secondary market as well. “With a maturity window up to 2058 and the goal to create that European yield curve, the continuation and refinancing of the expiring bonds will also become important for the long-term acceptance of the bonds, creating more confidence for investors,” she said. While the percentage of international investors in Sure bonds was reasonable at around 20%, this probably needs to be increased over time, she added.
Frey-Hartenberger noted that Eurex is committed to supporting the overall development of the EU’s bond programme by trying to integrate the bonds into its existing framework of exchange-listed and cleared products.
The EU Sure bonds are already eligible for trading on Eurex repo market and are eligible as margin collateral at Eurex Clearing, as NGEU bonds will be. There will also be new products related to fixed income environmental, social and governance, and green bonds investing.
Razauskaite supports the move. “We definitely see huge demand for impact products from retail and institutional investors trying to grab an opportunity to diversify their portfolios,” she said. Investing in green or social bonds, or the EU bond issuance, is a way to build a futureproof climate or socially resilient portfolio, lessening the risk of stranded assets, she said. Green bonds are becoming a viable option to fully or partially replace the traditional euro repo portfolios.
“Over the past few years we’ve seen demand for impact products outstripping supply, and therefore these kind of products perform very well. We expect this to continue in the long run.”
An NGEU future
When it comes to derivatives, Deutsche Bank’s Hilger sees demand for a futures product based on the NGEU issuance. “A future will definitely add liquidity because it would be a perfect hedging instrument,” she said. She explained that a lot of asset managers prefer not to take profits on bonds holdings because they need the carry income and it is difficult to re-enter at a decent level. But they could express that view by shorting a future, making it is easier to trade in and out.
Frey-Hartenberger agreed, but stressed the importance of timing. “For the moment, existing European fixed income futures products are considered to work very well for trading and hedging the Sure and NGEU bonds in the early stages.” She noted that German and French futures are currently being used for hedging the EC supply and as a proxy reference for pricing and hedging the Sure bonds.
“But, given the strong approach of the EC to implement this project – starting as soon as possible in 2021 – new futures products [may be required] by the second half of 2021,” she said.
She said she would consider any potential new listed products as “complementary and not competitive” to the existing Eurex fixed income offering. Hilger agreed that the development of new futures is unlikely to cannibalise any demand in the current futures market.