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The EU recovery fund’s impact on debt capital markets

Following a five-day marathon summit, EU leaders agreed on a €750bn recovery fund to help European economies because of the devastating effects of the pandemic. To finance the fund, the commission will be borrowing up to the full amount from financial markets via bonds. About €390bn of this will then be distributed as grants and the remaining coming in the form of loans to member states. This is the first time the EU has ever borrowed jointly as one large group, a move that has been taken rather well by debt capital markets. 

Pooling risk is largely beneficial

One of the greatest impacts investors have felt from this news is that it addresses a taboo of the EU: the notion of members pooling their risk by borrowing jointly instead of individually. As a singular unit, the EU has been given a triple-A rating by agencies such as Moody’s, Fitch, DRBS, and Scope, with S&P Global giving a lower rating of AA. S&P hailed the move as a “breakthrough” for the creditworthiness of EU member states. This high rating will allow the EU to borrow unprecedented amounts, so countries like Italy will now have access to cheaper financing, taking the pressure off their own bonds. Currently, the markets have seen the spreads of European government bonds tighten and the yields of peripheral nations drop significantly, with Italy being the key beneficiary. Going forward, it is expected that peripheral spreads and yields will grind lower still, but perhaps now at a slower rate. 

The move towards joint borrowing will also address the lack of a big pool of “safe” assets, one that could be comparable with the $17tn US treasury bond market, which is one of the euro’s drawbacks for reserve managers at the moment. Currently, no European sovereign debt is anywhere near the size of US treasuries, with German, French, and Italian outstanding bond market debts combined totalling less than half that of the US. Also, out of those three nations, Germany is the only one to currently hold a triple-A rating. 

The announcement has also impacted equity markets

The European Commission promising greater fiscal unity, has inspired greater confidence among investors that Europe warrants a bigger slice in their portfolios. This is because there is a reduced threat of institutional weakness in the single currency and the possibility of sovereign debt turmoil, avoiding a repeat of the sovereign debt crisis. In recent months, the US yield advantage has largely evaporated; the differences in real yields between the US and other leading economies such as Europe has significantly narrowed. Dividend yields on stocks now look more appealing than sub-zero Eurozone government bond yields, which should continue to encourage asset allocators to search for growth and value in equities.

An indirect “green” benefit of the fund may arise 

Included in the recovery fund is the EU Commission planning to target 30% of the funding to climate-friendly projects. This means that a third of the €750bn could be financed via green bonds, S&P Global predicts. If this were to come to fruition, it would boost the size of the global green bond market by 89%, with green bonds currently just comprising 3.7% of global bond issuance. Following the commitment to fighting climate change, this could lead to the utility sector being a beneficiary through the “green” focus of investments, possibly leading to the sector becoming more popular with investors as areas such as renewable energy benefit. Many investors are praising the EU for taking this initiative to ensure the pandemic recovery puts the climate first, especially as more investors begin to look for ESG investments. This could lead to any green bonds issued being quite popular. 

It may take a while for the fund to have its full effect 

The EU recovery fund may be playing a largely symbolic role currently, with the direct impact of the fund expected to be fairly modest in comparison to the economic damage caused by COVID-19. It is thought the fund will deliver a 6-7% boost in economic growth to European economies, and this boost will take months to begin to materialise and years to have its full effect. But the real impact of the fund is the effect it has had on investor confidence. It has been likened to Mr. Draghi’s pledge to do “whatever it takes” to protect the euro in 2012, a phrase that instantly instilled confidence among those watching. It looks like this has worked, with markets delivering an immediate seal of approval through the euro’s surge to a near 2-year high against the dollar following the agreement. The fiscal solidarity between nations is something investors have welcomed- they felt it had been lacking during the previous crisis, whereas this time the bowing of frugal nations to the pressure for joint borrowing shows a greater sense of unity. Therefore, currently, it looks like the EU recovery fund has done the trick to get investors on their side, but the long-term effects of its implementation will be a true testament to its success.


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