2020 was a challenging year for European bond investors, but an attempt by the European Central Bank (ECB) to stimulate an economic recovery in Europe has provided cause for optimism, writes Lidia Treiber
The bond market sell-off witnessed in March 2020 saw yields rise to all-time highs for some asset classes. Since then, the amount of negative yielding debt had been steadily on the rise, hitting a new decade high of $18.4trn in December 2020, before ending January 2021 at $16.8trn.
During the period of rising negative yielding debt, central banks massively expanded or reignited their quantitative easing programmes.
We have already seen an unprecedented demand for bonds issued under the SURE programme."
Looking specifically at European sovereign bonds, the general picture was very similar with yields falling from the peak seen in March 2020.
The first quarter of 2020 saw a rapid spread of covid-19 across the continent resulting in European economies shutting down - something modern society had never seen before.
It was no surprise that the unconventional and protracted measures would ultimately lead to a contraction in eurozone gross domestic product (GDP) during Q1 and an even larger drop in the second quarter, even outpacing the levels witnessed in the great financial crisis.
Unlike in prior crises, the ECB did not hesitate to launch a new quantitative easing (QE) programme. The pandemic emergency purchase programme (PEPP) was announced in March 2020 with an envelope of €600bn only to be increased to €1.35trn just three months later.
By the end of the year, the ECB expanded the size of the PEPP to nearly €1.9trn, extending the time horizon to at least March 2022 and increasing subsidised long-term loans for banks to help stimulate lending to the real economy.
The ECB had previously indicated that European Union member states would need to unify in times of crisis to support an economic recovery in the eurozone - this idea gave new life to EU bonds.
Adopted by the European Commission (EC) in May 2020, the SURE initiative will be funded by up to €100bn of new joint European Union debt issuance. This programme focuses on helping EU member states revive their labour markets amid the pandemic.
To encourage demand from investors, bonds issued under SURE fall under the EU's social bond framework, highlighting that the European bond market is shifting towards becoming more ESG aware.
Shortly after the SURE initiative, the European Commission (EC) put forward the NextGenerationEU programme with a significantly larger envelope of €750bn aimed at funding the eurozone's economic recovery.
As these programmes will help increase the issuance of social or green bonds in the market, the EU is sending a clear message that it will do 'whatever it takes' to stimulate the economy while demonstrating its commitment to sustainable finance as it aims to build a greener and more social Europe.
The EU long-term budget 2021-27, together with NextGenerationEU, forms the largest stimulus package ever financed through the EU budget totalling €1trn.
The ECB has long been judged on its ability to fulfil its QE programmes and faced limitations on sovereign bonds purchases, which have been guided by the Eurosystem capital key of national central banks.
The capital key provides guidance on the ratio of government's bonds that the ECB can purchase from each eurozone nation.
Given the extraordinary economic situation that the pandemic has caused, the PEPP was given greater flexibility if needed to support the smooth transmission of monetary policy.
Ultimately, greater flexibility could allow purchases of European government bonds and supranational bonds under PEPP to be tilted as required to prevent a tightening of financing conditions which could weigh negatively on inflation.
Historically, the EU was not a dominant borrower in the bond market, but the expected EU bond issuance of €850bn will transform the European bond market and supranational space.
Through the SURE programme and the NextGenerationEU initiative, the EU is set to become the second largest AAA-rated issuer in Europe and the largest supranational bond issuer in Europe.
With such a high credit rating, EU bonds have shown to be significantly more correlated to German bonds than to European corporates. They are also offering higher yield relative to German government bonds for similar maturities.
European Union bonds could draw some parallels to US Treasuries which are not linked to one US state but provide funding for the US economy.
We have already seen an unprecedented demand for bonds issued under the SURE programme. The first round of fund raising attracted the highest ever demand for a bond sale, at more than €233bn.
The latest issue of bonds was, again, oversubscribed and a trend we expect to see throughout SURE issuances owing to the EU being a high-quality issuer and an ESG element attached to the debt.
We expect the NextGenerationEU initiative to capture a lot of interest once bonds start being issued.
These grand measures taken by the ECB and EU amid the pandemic are monumental steps towards a greener and more unified Europe, while laying the path to rebuild the European economy.
Lidia Treiber is director of research at WisdomTree