JPMorgan, Citi weigh potential from EU bonds change

Money managers are piling into the European Union’s bonds in anticipation of a major shift in their status that would open up the bloc’s debt to a bigger pool of investors.

MSCI Inc. this week started a consultation on whether EU debt should be added to its sovereign bond indexes, following a similar proposal by Intercontinental Exchange Inc. last month. 

Fund managers at J.P. Morgan Asset Management, Royal London Asset Management and Barings are among those supporting the inclusion — the prospect of which has already erased the premium that some EU bonds used to pay over lower-rated French notes.

It’s a thorny concept, with the EU politically divided on many traditional hallmarks of sovereignty, including joint debt issuance itself. Benchmark providers currently class the bloc’s nearly €500 billion ($539 billion) of index-eligible bonds as a supranational, alongside state-run development banks and multilateral lenders, in benchmarks tracked by a far smaller cohort of investors.

EU officials hope that a reclassification would lower borrowing costs, an expectation that’s backed up by the latest market moves. The bloc’s AAA bonds have been outperforming those of its member states, and Citigroup Inc. estimates 10 basis points of the recent decline in spreads is due to index inclusion speculation.

“From a market point of view, they do look like government bonds,” said Seamus Mac Gorain, head of global rates at J.P. Morgan Asset Management. While he says there is “some ambiguity” about whether the EU itself is actually a sovereign, he reckons the bonds should get the nod for index entry regardless. 

Societe Generale SA analyst Ninon Bachet forecasts investment flows of up to €10 billion if the EU is included in sovereign bond indexes. Recent analysis from Commerzbank SA, Citigroup Inc. and JPMorgan Chase & Co. predict further outperformance. 

“The more people for whom these bonds become an eligible or a necessary holding, the more of a squeeze it’s going to cause,” said Gareth Hill, a portfolio manager at Royal London Asset Management, who favors sovereign index entry. 

The next development is likely to be the MSCI’s verdict on its survey at the end of May, followed by ICE’s decision in August. Other firms such as S&P’s iBoxx are yet to open formal consultations. Bloomberg LP, the parent company of Bloomberg News, also offers index products for various asset classes through Bloomberg Index Services Ltd.

Barclays Plc analysts said in a note last month that Bloomberg and S&P are meant to discuss the topic at index reviews in the fourth quarter of 2024. S&P and Bloomberg Index Services declined to comment. FTSE Russell, which owns the WGBI benchmark, said the issue was “on its radar.”

Index providers are already grappling with the sheer weight of EU bonds in their supranational indexes: they comprise over a fifth of a Bloomberg supranational gauge, up from less than 5% just four years ago. Continued heavy issuance means that by 2026 it could constitute over 60% in supranational benchmarks, according to Barclays research.

ICE and MSCI said they would make up approximately 5% of their European government bond benchmarks.

SOME OBSTACLES 

One potential hurdle to reclassification is that under current rules, the EU will cease additional net borrowing from 2026 when its pandemic-relief program expires. While there are discussions about additional issuance to fund items such as defense and climate, calls for permanent joint borrowing have been steadfastly opposed by the bloc’s economic powerhouse, Germany.

There’s also the argument that the EU isn’t technically a sovereign because it isn’t an independent government with tax-raising powers. Mark Dowding at RBC BlueBay Asset Management is among those who say EU bonds “don’t pass the smell test” when it comes to a conceptual definition of a sovereign, though he says that’s unlikely to prevent them entering sovereign indexes.

There are other reasons why designating the EU as a sovereign is favored by all sides. A sizeable bond market can boost the euro as a reserve currency, and improve confidence in the resilience of the European project. The EU’s pool of bonds is already the fifth largest in the region and is expected to swell to almost €1 trillion by 2026. 

Investors, meanwhile, would welcome more AAA-rated sovereign paper, which is scarce after last year’s US credit downgrade. Barings portfolio manager Brian Mangwiro thinks reclassification will at a stroke resolve Europe’s regular shortages of safe securities used as collateral to obtain cash. 

While the European Central Bank does accept EU debt as collateral, they are not widely used because clearing houses apply a far larger “haircut” than on bonds from similar or even lower-rated sovereigns. Bringing EU bonds into the fold as collateral will drive down their yields even further, Mangwiro predicts.

“We are already long and we don’t plan to lighten up,” he said.

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