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Institutional Perspectives

Although the eurogroup decided against bold action, they did leave open the possibility for future discussion of coronabonds and other related debt mutualization structures.

In south Europe, where the costs of the Covid-19 virus are set to exacerbate hefty pre-existing debt piles, there was some hope early in April that a eurozone group meeting would come to an agreement on the issuance of so-called “coronabonds” to combat the health crisis.

The idea was to let the European Central Bank (ECB) mutualize (i.e., combine) the sovereign debt of eurozone nations onto the ECB’s balance sheet and issue new ECB-backed coronabonds for the entire zone.

Ultimately, the eurogroup meeting ended with a €100 billion commitment to unemployment insurance, €200 billion in loans for companies (leveraged from €25 billion through the European Investment Bank ), and €240 billion for credit lines through the European Stability Mechanism.  

But there was no agreement on coronabonds.  

As the Dutch finance minister, Wopke Hoekstra, commented, “It is actually very simple. Eurobonds is [sic] a thing I wasn’t OK with, I am not OK with and I will never be OK with,” according to published reports after the meeting broke up. Not surprisingly, the Germans were no less firm in their opposition, sparking vocal protests from lawmakers in the south, notably Italy, Spain, and Portugal.

The division between the north and south of Europe, which Jean-Claude Trichet, former head of the ECB, has called “counterproductive” and “useless,” is nothing new to the region, which has been in disagreement over the management of sovereign debt since the eurozone debt crisis of 2011.

For that reason, market expectations were rather low headed into the meeting. Nonetheless, Italian bond spreads widened relative to Germany in the aftermath, suggesting some disappointment with the outcome and expectations of greater bond issuance by already debt-burdened Italy.

 

Figure 1. Italian Government Bonds Underperform in the Aftermath of the Meeting
Italian and French bond spreads, percentage over Germany (January 3, 2005-April 15, 2020)

Source: Bloomberg.

 

In my view, it is still politically difficult for some northern countries to agree to mutualized debt instruments. It is also difficult for the eurogroup to decide on a level of conditionality (i.e., the level of fiscal monitoring required following the agreement for participating countries, like debt sustainability requirements) that would be attached to these instruments. As a result, some southern countries like Italy and Spain are spending less on direct fiscal outlays than may be needed due to fiscal constraints.

Given the intransigence at the eurogroup level, some countries are boosting their fiscal outlays knowing the supranational level will not be forthcoming with additional funding.  As reported by Reuters, Italy last week upsized its credit guarantees to a total of €750 billion, and France doubled its crisis package to around €100 billion.

These governments are moving ahead because the implicit plan now is to get around northern countries’ concerns about debt mutualization through ECB purchases. The ECB has committed to buying government debt in order to combat pressure on government finances through higher interest rates. All national central banks in the eurozone have a share of the capital of the ECB so this is effectively indirect burden-sharing.

 

Figure 2. The ECB Returns to Balance Sheet Expansion
Growth of ECB balance sheet, millions of EUR (1999-April 15, 2020)

Source: Haver Analytics.

 

Of course, markets may press policymakers for more forthright measures. Moreover, although the eurogroup decided against bold action, they did leave open the possibility for future discussion of the coronabonds and other related debt mutualization structures.

One can hope that Europe will ultimately look to their common firepower as an advantage. Issuing crisis bonds backed by a large economic area with substantial future prospects must surely be more advantageous, in my opinion, than some other individual countries’ efforts to keep up with the fiscal deluge. For example, the Bank of England (BOE) has recently decided to directly finance the government’s debt, effectively shielding fiscal outlays from bond markets for a limited time period. Only time will tell whether the BOE’s decision was innovative or will be harmful in the long run.

 

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Although government treasuries are considered to have low credit risk, they are affected by other types of risk—mainly interest rate risk (when interest rates rise, the market value of debt obligations tends to drop) and inflation risk.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

Bloomberg Barclays Index Information:

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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