The topic of the European Union's inclusion in sovereign bond indices is heating up. The primary beneficiary would be the EU's own spreads, but the ramifications for Europe's sovereign issuers run far beyond that. The long-term benefits outweigh the costs.
Last week the MSCI launched a consultation on whether EU bonds should be added to sovereign bond indices after peer provider ICE had launched a similar consultation on April 9.
MSCI's consultation is important. It has a much larger following in the sovereign bond market than ICE. That in turn will put more pressure on the biggest providers like Bloomberg and Barclays to follow suit.
Sovereign bond index inclusion has been high on the EU's agenda since it ramped up its borrowing programme to around €150bn a year to support the bloc's recovery from the coronavirus pandemic. It has issued €463bn of bonds since June 2020, including a €6bn 3.375% October 2054 on Tuesday.
In April, the EU said that in a survey of its investors, respondents considered sovereign index inclusion to be the “the single most important remaining step in order for EU bonds to trade and price similarly” to European government bonds.
The size of the EU's borrowing programme is certainly sovereign-like, and it has adopted sovereign-style techniques to issue it all, such as committing to issuance dates long in advance. It also auctions bonds in addition to the jumbo syndications that included Tuesday's deal, and has a bills programme for shorter term borrowing.
Sovereign bond index inclusion would increase structural demand for EU bonds, lowering its borrowing costs. A broad sweep of investors follow the indices with passive investment strategies, committed to replicating the indices. They have outstripped active investors for the first time ever this year.
MSCI estimates that, should EU bonds be included in its Government Bond Index —Developed Markets, they would have a weighting of 1.5%, representing its debt stock of €467bn.
But the attempt to make it into sovereign bond indices has its critics, not least the indices' current occupants.
Privately, it is said that sovereign bond issuers within the EU are dead against the idea. Their argument is a simple one: the EU is not a sovereign.
A key feature of government bond markets is that they are simple and homogeneous. Several sovereign issuers balked at the idea of issuing green bonds, for example, as they are loath to do anything that risks diluting or devaluing their core securities. The EU would have that effect on the indices, goes the argument.
They are also said to be concerned that if the EU joins their indices, sovereign borrowing costs would rise, as investors buy more from the bloc instead of from them.
Inevitable closer union?
The EU is not a sovereign. But it will be hard to resist its inclusion in the indices because so many parties stand to benefit.
The obvious two are the EU, for the reasons mentioned, and the index providers, which are running businesses that will benefit from being the first to serve investors and the issuer with what they seem to want.
But there are perks for the EU's sovereign issuers too, and also for the EU as a political and economic entity.
Sovereign bond index inclusion is more than a technical adjustment whose impact is confined to the capital markets. It is a step that aligns with the long-term goal of building a Capital Markets Union — the EU’s flagship initiative aimed at unifying capital markets across the bloc.
The stalled CMU project was recently put back on the EU's agenda as the Savings and Investments Union. Having a common European 'safe asset' via bonds issued at the EU level forms an important part of that agenda.
The volume of bonds issued by the EU's top supranationals — the EU, European Investment Bank, European Stability Mechanism and European Financial Stability Facility — rose above €1tr for the first time in March, according to a paper presented at an EU summit by Italian politician Enrico Letta in April.
“These are all triple-A [rated] assets, fully backed one way or another by European sovereigns,” wrote Letta. “However, while these supranational bonds are close substitutes, they are traded separately, which hurts their pricing, given the relative lack of liquidity coming from the still limited and fragmented issuance.”
Trend with benefits
The EU has demonstrated that integration brings extensive benefits, especially in times of crisis.
Not only do member states enjoy the world's largest single market for goods and services. When the region was hit by the pandemic, the EU produced the €807bn NextGenerationEU programme it is now funding in the bond market, and before that the roughly €100bn Support to mitigate Unemployment Risks in an Emergency (SURE) programme. Both used joint bond market funding powerfully to help member states recover from an economic shock.
To worry about its own immediate borrowing costs is of course the very job of a country's debt management office. But, especially in a crisis, if anyone benefits at all from cheaper EU borrowing costs, it will be the member states those DMOs work for.
CMU has made slow progress because, in part, member states have been reluctant to cede regulatory power or to accept short term financial disadvantages.
Yet when it came to the crunch, member states benefited enormously from crisis recovery programmes like NextGenEU and SURE. Going to the bond market is surely now right at the front of the EU's crisis playbook.
At a fundamental level, the EU exists because individual countries are willing to make concessions and give up a degree of political and economic authority for the collective's greater good.
Countries should recognise that EU bonds being seen in the market more like sovereign bonds is another example of that principle.
Sovereign bond inclusion for the EU seems inevitable. Its member states should worry less about the finer points of what it might cost them in the short-term and instead, embrace the long-term benefits it will bring.