EU rebuilding

SSA Special Report 2021
20 min read
Nick Herbert

Fresh from its SURE-fired funding success in response to the economic impact of Covid-19, the European Union is set to embark on a next generation programme that will lift it to one of the biggest borrowers in the bond market.

The European Union's move towards the next stage of its borrowing programme comes with significant implications for euro markets, ESG financing and the bloc’s economic and monetary union itself.

Triple A rated EU is not new to bonds but, until 2020, its approach to wholesale financing in the capital markets had been limited to relatively small sizes in comparison to the magnitude of the overall EU economy. In 2011, for instance, the last time it accessed the bond markets with any real urgency, it raised just under €30bn as part of the European Financial Stabilisation Mechanism. Funds from the EFSM were dispersed to those member states suffering in the wake of the European sovereign bond crisis.

Until the onset of Covid, EFSM had been one of three loan programmes funded by bond issuance, the others being a balance of payments assistance programme for on-lending to non-euro area members of the EU and another smaller scheme for non-EU countries, the Macro-Financial Assistance programme. Borrowing had bobbed along at a relatively modest yearly rate of €5bn–€10bn.

“Suddenly it was Covid,” said a senior EU official.

Share prices dropped 25%, bond yields surged, and lending dried up.

“We had to pull out all the stops, as everyone was looking for liquidity,” said the official. “It became a question of how we could use a largely dormant funding capacity on a much larger scale to help fund temporary employment schemes.”

The answer came in the guise of the SURE (support to mitigate unemployment risks in an emergency) back-to-back lending programme, a facility capped at a maximum €100bn with lending designed to assist member states cope with the financial pressures associated with preserving employment. It was all to be financed through the capital markets.

The European Commission proposed the creation of the programme on April 2 2020, and by May 19 the Council had signed off the proposal and adopted SURE regulation.

“It was all approved very quickly,” said the EU official. “It proves the European Union can act fast when it needs to and shows impressive solidarity and support between the member states.”

And there’s more . . .

SURE lending addresses the costs associated with temporary employment issues but, with the European economy plunged into its deepest contraction since World War II, longer-term recovery plans from Covid were also required. Step forward the European Recovery Plan.

Receiving approval for the Recovery Plan proved a tougher nut to crack than ratification of SURE due to changes in proposed methods of dispersals and the consequent implications for member states' budgets. On July 21 2020, the Next Generation EU (NGEU) fund was agreed by the Council, authorising the European Commission to tap the capital markets on behalf of the EU once again, this time for a total of €750bn until the end of 2026. The temporary recovery instrument provides grants and loans to both help repair the damage inflicted by the pandemic and to build back the economy in a greener, more digital and resilient way.

Funding will be provided over and above the European budget for 2021–2027 and is centred on the Recovery and Resilience Facility. The €672.5bn RRF facility is split between €360bn of loans and €312.5bn of grants to help finance investment projects within the member states that grow a resilient economy.

The presence of transfer payments represents a significant change to the conventional character of EU capital markets financing, where debt was traditionally issued to fund loans.

“In the past, EU issuance was repaid from proceeds of the loans,” said Arnaud Louis, head of supranational ratings at Fitch. “The novelty this time is that the grants funded in the capital markets will be repaid through the general EU budget. It means that if the EU runs out of liquidity, it can go back to its member states and ask for additional funding – capped to the own resources ceiling.”

As part of the financial framework for 2021–2027, the EC has adopted a new Own Resources Decision that will raise the ceiling on the volume of resources that can be called from EU countries per year from 1.2% to 2.0% of EU Gross National Income.

“The increase is significant, representing around €100bn in funding per year,” said Louis.

This change brings with it a political dimension, since raising the maximum total of Own Resources could be taken as one more step towards a fiscal union, given that debt service for the Triple A borrower will, effectively, be fully covered by the five top-rated member states – Germany, the Netherlands, Denmark, Sweden and Luxembourg.

“The plan has been agreed at the political level but it needs to be ratified by each of the member states before funding on the capital markets can begin,” said Louis.

Ratification is expected to be completed by June.

Once approval is in place, the EU is ready to hit the bond markets and it plans to hit it consistently, and in size, over the next few years.

“On NGEU bonds, we expect issuance volumes of up to €150bn–€200bn annually until end 2026,” according to the EU official. “We will become one of the largest issuers in the euro market.”

Mille feuille

Together with financing the remainder of SURE and other ongoing programmes, funding NGEU will see the EU borrowing close to €1trn by 2026. The EU is transforming itself from a second-tier borrower into the largest supranational debt issuer in the international capital markets and raising its issuance volumes to a par with some of the biggest European sovereigns. Its transformation has many implications.

“The EU is set to become the dominant EU-level bond issuer, offering investors a new type of euro safe asset,” said Jan von Gerich, chief analyst at Nordea. “It’s something the market’s been waiting for and something it has needed for some time. It will help improve the functioning of European financial markets as a whole.”

As EU President Ursula van Der Leyen highlighted during her State of the Union address of September 2020, deep and liquid capital markets are essential in giving businesses access to the finance they need to grow, the finance needed to invest in the recovery and the future. She also pointed to the contribution that more efficient markets would make in further strengthening the international role of the euro as a reserve currency.

While the planned EU issuance will not compete in terms of outstanding volumes with German government bonds (the current go-to safe haven in the euro area), NGEU does represent a step towards an EU-wide safe asset, at least for the life of the programme. But if, as some speculate, issuance continues after this current closed-end NGEU programme is wound down, then an EU-level safe asset could become a more permanent feature.

SURE footing

Whatever the longer-term future holds, there is unquestionable demand for liquid EU debt right now, as the response to its first foray into the markets under SURE testifies.

SURE issuance began in October 2020, when the EU launched a two-tranche €17bn deal to a rapturous response. A response so rapturous that it uncovered the biggest order book for any public bond offering in history.

“All the news around SURE and NGEU made the market sit up,” said the EU official. “It helped build awareness of the EU becoming a regular, large-scale benchmark issuer of a new highly rated euro credit. In addition, the social bond label of SURE proved to be another positive contribution to the deal’s reception.”

Comprising €10bn of 10-year and €7bn 20-year social bonds, the deal was met with interest from investors amounting to €233bn. The clamour for paper resulted in both notes tightening by around 10bp in the first few days after pricing.

Subsequent visits to the market proved equally successful as the EU moved quickly to build a liquid reference curve. Each note was limited to a maximum €10bn in size.

Impressive post-launch performance did bring with it, however, questions as to whether the borrower was giving too much away to investors. Nevertheless, as the issuance programme developed, so the EU began to find a degree of equilibrium in terms of primary market pricing in relation to its curve and to its peers.

“Did it pay too much?” considered Sylvia Moussalli, head of SSA and bank origination at Commerzbank. “The first three deals certainly priced at a premium, but that was necessary to get the programme off the ground; there was no room for failure. But now it has found a new home in terms of relative value, and that’s largely inside the European Investment Bank and France but wider than Germany.”

Irrespective of any pricing concerns, the EU has unarguably achieved a tremendous amount with a small team in a short space of time. To assist in its efforts, the funding team has been supplemented by secondments from other debt management offices in Europe. It has been a successful exercise.

“The deals have priced well, been well received,” said the EU official. “And we’ve very quickly established a liquid curve from five years out to 30 years.”

Changing its spots

All the SURE deals came to market as syndicated transactions but, with the size of its borrowing increasing so dramatically, the EU can no longer rely on its previously preferred tried and trusted method to raise funds.

“Funding the Recovery Plan will need a diversified funding strategy more aligned with sovereign issuers,” said the EU official. “Financing will need to be structured and predictable but allow us to react to market conditions and be agile in mobilising liquidity as needed. It will undoubtedly build on the lessons learned with SURE, but we need a different tool box for NGEU.”

Issuance evolution means the borrower moving away from an exclusive dependence on syndicated transactions, although those types of deals are not excluded as part of the borrower’s armoury – possibly as a means of introducing new lines to the curve. There will, instead, be regular auctions with NGEU issuance supported by liquidity management tools, a T-bill programme and support for liquid secondary markets. There is no decision as to a cap on the size of each tranche for NGEU.

With this in mind, the EU is investing to upgrade its organisational structure, work processes, risk management and staffing. Success will require cooperation with peer supranational borrowers and other major issuers to ensure a measured and concerted approach to tapping the markets in terms of timing and targeted maturities.

“We’re conscious of being the new kid on the block,” said the EU official. “We have to be conscious of the borrowing plans of other SSA issuers and sovereign debt management offices. It will need a coordinated approach.”

There is a lot of money to be raised in a short space of time, so visits to the market will need to be managed.

“We expect there will be an element of predictability,” said Moussalli. “That will be helpful particularly for the bills, but we don’t expect it will take the same, fixed calendar funding route as Germany, for example. That wouldn’t leave it with enough flexibility.”

NGEU issuance is expected to begin during this summer once the Own Resources Decision has been ratified. Time is of the essence.

“It will be good to go as soon as possible in early summer,” said the EU official. “The need within the member states is great. We must respond to that need as swiftly as we can.”

Green and social is good

The appearance of a regular, major issuer such as the EU is guaranteed to deepen euro markets overall, but issuance from SURE and NGEU also represents a boost to sustainable finance. Issuing 30% of the NGEU programme as green bonds is a bold statement on behalf of the EU. It underlines the EU’s commitment to the European Green Deal.

“Two hundred and twenty-five billion euros in green bonds is a real vote of confidence for the market,” said Mitch Reznick of Federated Hermes. “It demonstrates the EU’s faith in the product as a credible source of funding.”

Green NGEU issuance provides an opportunity for the EU to put its money where its mouth is in respect to addressing climate change. The bloc is already contributing to the market’s development in terms of definition, standardisation, transparency and reporting to mitigate the spectre of greenwashing. Now, it has the chance to reap the rewards of making the product more investible to finance the physical projects needed to realise its zero-carbon ambitions. It will not wait for all the sustainable finance regulations to be signed off before beginning issuing, however.

“Our NGEU green bond framework will be robust and credible and integrate as much as possible from the climate taxonomy and the EU green bond standard which are still in the making,” said the EU official. “But the framework must also reflect that it is the member states which decide and implement the investments funded by the Recovery Plan and provide the information on their eligible green expenditures”.

The EU is going through the mechanics of establishing a green bond framework and will be ready to come to market upon completion.

“Everyone would benefit from a transparent framework,” said von Gerich. “The EU is in the right place to set standards for the market, and that will make it easier for other issuers to follow.”

As well as advancing the potential of the ESG market, there is also mounting evidence that going green brings with it the prospect of reduced cost of funds. The German sovereign in September 2020, for instance, launched a green Bund at a spread of 1bp inside a conventional tranche issued at the same time. That green bond then outperformed in the secondary market.

“A small greenium has existed for some time in the debt markets,” said Reznick. “But, really, it’s very small for the highest-of-quality issuers, especially at prevailing levels of interest rates. Of course, a scarcity factor amplifies any premium, but even if there is a benefit for the EU going green to begin with, it will likely diminish over time as outstanding volumes increase.”

Whether the EU finds a greenium or not, ESG-labelled bonds generally bring the added advantage of cementing a deal’s attractiveness in terms of investor diversification. The broader appeal for assets sporting a social tag was evident for the SURE bonds.

“The social label may not have been the deciding factor in the success of the SURE deals,” said Moussalli, “but it was definitely helpful in tempting investors into participating.”

And the ESG halo effect is likely to be even more apparent for the first green deals from NGEU, since the number of asset managers sitting on exclusively green mandates far exceeds those with social dictates.

“This will be a specialist bond but with broad appeal,” said Reznick. “Buyers of this product go beyond just green bond buyers. It’s a government bond that many will want in order to strengthen their sustainability credentials.”

Long-term friends with benefits

As well as shoring up short-term employment and financing investment to rebuild the EU economy sustainably, there may be an additional longer-term precedent being established. It could propel the EU to closer cooperation and lead to NGEU being replaced by a regular programme of centralised bond issuance, one that would result in an EU-wide safe asset to compete with the German proxy.

There would need to be some changes within the member states first, though, for this to transpire.

“Some countries face a challenge,” said Michele Napolitano head of Western Europe sovereigns ratings at Fitch. “Some of them will not have the infrastructure to absorb significant amounts of funds at first, but as their ability to improve investment practices increases, so the greater the chance this programme has in succeeding.”

This is, perhaps, where the discipline, checks and balances integral to investing funds raised through green bonds and destined to mitigate climate change, are likely to accelerate the ability of member states to digest greater levels of investment.

“If they are successful with NGEU, then we think they might consider using it again,” said Napolitano.

The attraction of raising funds centrally is also likely to become more pronounced towards the end of the NGEU programme, once grants have been disbursed and lending begins. Then, the difference between where member states can borrow from the EU and where they could borrow independently in the capital markets will become more apparent.

Centralisation of resources and the provision of grants will improve the ability of the EU to address asymmetric and countercyclical shocks that adversely affect the lower-rated members states.

“It is no free lunch,” said Napolitano. “But any potential negative impact on the Triple A members backing the budget could be offset by an increase in economic activity in their close trading partners. It could be a win-win.”

In the longer term, the path to the bloc’s greater stability and competitiveness may be through deeper economic and monetary union.

“Many step changes in history are born out of necessity,” said Moussalli. “And the pandemic may well end up being responsible for speeding up the move to closer fiscal coordination in the EU.”

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