The European Union’s (EU) debt pile is set to reach €900 billion by the end of 2026 as the bloc borrows to fund coronavirus recovery programmes and support for Ukraine, but investors are finding its bonds less attractive than some of those of individual European countries.
The bloc’s own bond issuance has grown since member states reached a historic 2020 agreement on common debt issuance for its NextGenerationEU programme, designed to help economies recover from the pandemic and support Europe’s green and digital transition.
From a low base, the EU has rapidly become a “real player” on debt markets, an EU official said.
“By the end of 2026, we will have €900 billion [of debt] outstanding,” the official added. “That stock of debt requires refinancing: we’ve got to make this market work because of that.” A debt pile of this size would make it the fifth largest in the EU.
However, Brussels’ ambitions to be an issuer on a par with individual European countries are being hampered by political reluctance to continue wide-scale debt issuance beyond 2027 and the bonds’ exclusion from sovereign indices. This has left investors uncertain over how big the market will be in future.
“The big question for the market is: was NextGenerationEU a one-off or is that kind of co-ordinated fiscal response now the template?” said Rohan Khanna, head of euro rates strategy at Barclays.
“Do we want to use it as a way of financing infrastructure projects and have a shared budget, with the EU more like a state?” added Andres Sanchez Balcazar, head of global bonds at Pictet. “I’m not sure there is the political will to go in that direction.”
The EU has €450 billion of debt in issue, a huge increase from about €50 billion in 2020. This is set to rise past €500 billion next year, as it funds pandemic recovery programmes, green investments and support for Ukraine, and reach €900 billion by the end of 2026, officials said.
The bulk of the funding relates to NextGenerationEU, which will be up to €800 billion in size and is set to end in 2027, with other borrowing relating to funding for Ukraine.
However, investors are demanding a premium to own the debt. Despite the EU’s AAA credit rating – higher than France’s AA rating – benchmark 10-year EU bonds trade with a yield of 3.6 per cent, compared with 2.8 per cent for Germany and 3.4 per cent for France. Yields move inversely to prices.
Investors point to the relatively small amount of bonds freely available to trade, making them less liquid, or more expensive to buy and sell. They also cite a lack of inclusion in sovereign bond indices, which investors use to benchmark their portfolios, stripping out a large pool of potential buyers.
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“If you are trading cheap versus France and Germany then you have a problem on your hands because it makes your borrowing costs higher,” said Khanna. “Trading [at a price] lower than France with a better credit rating is a challenge.”
The European Commission is trying to encourage the development of the secondary market to boost liquidity and attract more investors. Officials said plans for a repo facility – allowing investors to borrow against the debt overnight – and a futures market for EU bonds next year were on track.
Futures contracts are derivatives through which investors can buy or sell underlying securities at a future date, allowing them to hedge their positions.
“If the EU creates a good repo and futures market – it will give the impression that it’s here to stay,” said Sanchez Balcazar. “That might help narrow the spread.”
The commission also hopes the debt will be included in indices to “strengthen structural demand for EU bonds”, officials said, but they added this would take time.
According to a survey of investors conducted by the commission, about two-thirds of investors would increase their exposure to EU debt if the bonds were included in a sovereign index, with half saying they would increase their exposure by a “significant” amount.
The anticipated slowdown in the EU’s debt issuance at the end of 2027, when NextGenerationEU comes to an end, is also putting off investors, said Grégory Claeys, a senior fellow at Brussels economics think-tank Bruegel.
“The commission says it will diminish [issuance] gradually but still the market will become less and less liquid,” he said.
The EU will have to start repaying borrowing for NextGenerationEU from 2028. The initiative is made up of a combination of grants and loans, with loans set to be paid off by borrowing member states while grants are paid out of the EU budget.
Borrowing costs borne by the EU and other issuers have risen as the European Central Bank has increased rates, with the rate of its deposit facility at 4 per cent, up from minus 0.5 per cent in July 2022.
This is especially an issue for the EU, which now faces higher than anticipated interest costs than it had budgeted for, in financial plans signed off by member states.
Johannes Hahn, the EU’s commissioner for the budget, said in August that interest costs would reach €4 billion in 2024, almost double the €2.1 billion previously anticipated, due to rising interest rates.
To meet higher costs from interest rates and other challenges, the commission faces the difficult political task of asking member states for more cash, in ongoing budget discussions.
“Finance ministers across the EU have to sell difficult budget cuts domestically in order to make up for rising interest rates. Asking them to cough up billions, simply so the commission can avoid similarly difficult choices is a political non-starter,” a European diplomat said. – Copyright The Financial Times Limited 2023
