Eurobonds: Are the proposals over-complicating the issue?

Even though Nicolas Sarkozy and Angela Merkel roundly discounted at their Tuesday meeting issuance in the short term of joint and severally guaranteed EZ bonds pending (take your pick) progress on fiscal union (Sarkozy) or reaching the last resort in the current crisis (Merkel), the debt market continues to be full of talk of what such a bond might look like.

As a starting point, everyone’s hastily blown the dust off the May 2010 Blue Bond Proposal penned by Jacques Delpla and Jakob von Weizsäcker of the Breugel Institute, the European think-tank. The same authors published a follow-up report in March 2011 at the request of the European Parliament’s Committee on Economic and Monetary Affairs and published under the umbrella of the Directorate General for Internal Policies (“Eurobonds: The Blue Bond Concept and its implications”).

Most recently, on August 17, Hans-Joachim Dűbel of independent financial sector consultants Finpolconsult published “Partial Sovereign Bond issuance by the eurozone – the more efficient alternative to the Blue (Euro-)Bonds”. Away from Blue Bonds, Citigroup’s Nazareth Festekjian proposed at the time of the original publication an alternative to bond issuance in the form of a CDS lookalike for sovereign bond creditors: the Euro Debt Assured Purchase (EDAP) agreement programme.

I reckon that if we do reach Merkel’s last resort before we get to Sarkozy’s fiscal union – quite likely in my view – there will need to be some sort of mechanism in place to prop up Fortress Euro, which was so robustly defended by the Franco-German axis on Tuesday.

The Blue Bond/Red Bond framework is highly original and worthy of serious consideration. The basic concept is that the EU issues Blue Bonds – senior sovereign debt with joint and several liability – up to the equivalent of 60% of GDP of aggregate EZ national debt. Each member of the EZ receives a Blue Bond allocation. Beyond this allocation, national governments can issue supplementary Red Bonds – junior subordinated stand-alone debt – with an appropriate risk premium tacked on and with procedures in place for an orderly default.

I’m still in the process of getting through all of the pros and cons of the discussion – there’s a lot of stuff out there – so I’ll follow up with some thoughts soon. But before I do, it’s worth pointing out that the Eurobond market (ie. the London-based offshore bond market created in 1963) has seen several examples of European supranational borrowers tapping the market where the issue of fiscal transfer or allocation of funds never comes up.

EIB’s sanctity

Take the European Investment Bank, the EU’s long-term lending institution. EIB is owned by the 27 member states of the European Union and its lending activities are basically funded by the bond market, where EIB is one of the global market’s bellwether issuers. Its 2011 funding programme is €70bn–€75bn. No one ever questions the sanctity of the EIB’s Triple A rating. And no one in the bond market frankly cares about what it does with the cash it raises in the market.

For all most debt-holders know, the bank could be raising cash from core EZ institutional investors and lending it to dodgy projects in dodgy peripheral EZ countries, or even further afield, to enlargement/potential enlargement countries and to emerging markets. (In point of fact, around 90% of EIB’s €72bn lending in 2010 went to EU countries, but I’m just making a point).

It’s the same situation with other European (EU and Europe-wide) supranational agencies in the bond market, be it the Council of Europe Development Bank, Eurofima and, in former times, the European Coal and Steel Community. And don’t forget that the European Union (and the European Economic Community in former times) has borrowed in the bond market on a regular basis with no cries of foul, and without invoking issues of fiscal transfer, leakage or whatever. My historical league table (1963 to-date) lists the organisations that have tapped bond investors for cash.

Anthony Peters, my fellow IFR blogger, picked up on this theme in July, using the example of Eurofima. “Take a look at Eurofima,” he said, “that treasury operation of the railway industry which is hidden away in a little 17th century burgher house in Basel. It is AAA/Aaa rated, it is jointly and severally guaranteed by its shareholders and it borrows at the finest rates in the market. How much it lends to the likes of Hungarian National Railways or Greek National Railways and at what rate is nobody’s business and so far as I can tell nobody has ever asked”. My point exactly.

Eurofima, the European Company for the Financing of Railroad Rolling Stock, has been borrowing regularly in the bond markets pretty much since its founding in 1956. It borrows an average of SFr3bn each year strategically via euro and US dollar benchmarks and in Australian dollars and Swiss francs (liquid lines across the curve in both markets), and more opportunistically in other bond market segments (outstanding bonds in 12 currencies).

Market veterans out there will know that Eurofima has been an agency bellwether for decades. Investors happily bid for its paper and no one ever questions its Triple A status. And frankly I doubt that anyone who holds its paper really knows what it does. Eurofima doesn’t disclose it lending activities, but for the record as a non-profit organisation, it passes on its funding cost plus a commission which, depending on the rating of the recipient, varies between 5bp and 50bp.

Perhaps I’m missing something, but I do wonder if everyone’s just complicating the issue a tad and focusing too much on issues of political/moral hazard at the risk of creating workable financing solutions. More on this soon.