EU bond bonanza sends ripples through derivatives markets

IFR 2390 - 03 Jul 2021 - 09 Jul 2021
6 min read
Christopher Whittall

The European Union’s debt sales funding its response to the coronavirus pandemic are creating a splash in derivatives markets, traders and analysts say, in a further sign of the unprecedented market impact of the blockbuster financing programmes.

Investors have scrambled to buy the EU’s new bonds in recent months, with deals coming from the unemployment-focused SURE programme as well as NextGenerationEU, a pandemic recovery fund that some analysts think could even rival German government bonds as the main risk-free asset in the eurozone over the coming years.

The frenzy has spilled over to derivatives markets as many investors have bought the bonds on asset swap, meaning they concurrently enter a swap contract to remove the interest-rate risk on the debt. As a result, swap spreads have widened relative to bonds around the time of nearly every EU deal since October.

There is no precedent for a single debt issuer having such a regular and notable impact on European derivatives markets – nor is there any sign of this dynamic fading anytime soon, traders say.

“The substantive size of these deals – and the expectations of the whole programme – have led people to think lots of bank treasuries will buy this paper on asset swap. That’s the reason for the ripple in swap spreads,” said Joe Squires, co-head of G-10 rates at BNP Paribas.

The EU has become one of the biggest issuers in European debt markets this year, having already raised about €90bn across its various programmes. That includes just over €50bn under SURE, which has already completed its funding needs for 2021, and another €35bn under NGEU. It intends to print a further €45bn in long-term bonds under the NGEU before the end of the year.

Investors have fallen over themselves to buy these new bonds, with the order book on the NGEU’s latest deal – a two-part €15bn transaction – surpassing €171bn last week.

Bank treasuries account for a sizeable chunk of that demand, buying just under a quarter (or about €22bn) of the seven SURE deals between October and May, according to the European Commission.

That has a knock-on effect in derivatives markets as bank treasuries, along with some other buyers such as hedge funds, will often hold the bonds on asset swap to shield them from potential paper losses if there is a sudden spike in interest rates. This swapping activity, where investors enter a derivative to switch the fixed coupons on the bonds for floating-rate payments, puts upwards pressure on swap spreads and causes them to widen against German Bunds.

Systematic widening

Adam Kurpiel, head of rates strategy at Societe Generale, said swap spreads have widened around the time of all but one of the seven SURE syndicated deals and after both the NGEU deals to come to market since last October. The move has tended to be the strongest on the day of the deal announcement, when investors and traders learn of the proposed bonds' tenors, and has peaked at 2bp on average, before fading a day or two afterwards.

“The effect is there. It’s happening systematically so far,” said Kurpiel.

Fabio Bassi, head of European interest-rate strategy at JP Morgan, said the moves in swap spreads were hard to disentangle from other dynamics influencing rates markets, such as investors hedging against a re-emergence of inflation since earlier this year. Even so, he said a model assessing the fair value of swap spreads currently indicates they are about 2bp to 3bp too wide – a potential sign of the impact of EU-related asset-swap activity.

“These EU-related flows have been putting upward pressure on the swaps curve,” said Bassi. “But it’s difficult to separate one thing from another as the main narrative in fixed income markets has really been driven by the willingness of investors to implement the reflation trade.”

While asset-swap activity is standard practice, it is unusual for one issuer to trigger notable derivatives markets moves on such a regular and consistent basis. If anything, bond issuance has historically been associated with a narrowing in swaps spreads – not a widening.

That is because an increase in bond supply usually causes bonds to underperform swaps, while the tendency of some issuers such as banks and large corporates to enter derivatives contracts to hedge their interest rate risk coming from their borrowings further compresses swap spreads.

This dynamic has led to some seasonality in swap spreads, which have typically narrowed when bond issuance is heavy such as in January and September, Kurpiel noted. But that effect has faded over the last year, he added, as banks' funding needs have declined and the low interest rate environment has discouraged corporates from swapping new debt sales.

“Much lower swappable issuance coupled with some investors buying paper on asset swap has created a dynamic on swap spreads which is maybe counter-intuitive,” said Kurpiel.

Known unknown

One great unknown hanging over the swaps markets is the extent to which the EU may use swaps itself from next year, potentially triggering more moves in derivatives markets.

The EU has said it will give member states receiving floating-rate loans under the NGEU programme the option of fixing their interest rates from 2022, which the EU would do through swaps hedges.

“The EU could implement some derivatives hedging on behalf of the countries borrowing,” said Bassi. “It’s not going to be imminent, though, so it won’t impact swap spreads in the short term.”