Like its emblematic flag, the pace of change at the European Commission’s debt office could have managers seeing stars. In 2021, only a decade after the EU sovereign debt crisis prompted the Commission to temporarily turbo-boost its annual bond issuance from €500 million ($568.3 million) to €30 billion – breaking its own borrowing record – Covid-19 has blown this number out of the sky.
Now, under its ambitious €800 billion Covid-19 recovery programme, NextGenerationEU (NGEU), the EC will average an astonishing annual issuance of €150 billion, setting it on course to become one of the largest debt issuers in the world.
“Before 2020, we were coming from a scale of very small issuance, issuing around €500 million of bonds in 2019. We’re now operating at a completely different scale of activity,” says Niall Bohan, director of the directorate’s asset, debt and financial risk management, which sits within the directorate-general for budget at the European Commission.
Designed to boost the economic recovery of EU member states through a series of grants and loans, the NGEU programme sees €412.1 billion mainly available for grants and €385.8 billion available for loans for the five-year period from 2021 to 2026. Last year, the supranational raised €71 billion worth of bonds to finance the programme.
It’s a trajectory with its feet in the start of the Covid-19 pandemic. In 2020, the Commission made a dramatic increase in its borrowing in a bid to mitigate unemployment risk stemming from the crisis. Boosting its issuance capabilities through its SURE back-to-back funding programme, which funds short-term work schemes in member states, the Commission had issued €39.5 billion of social bonds by the end of that year.
While not a sovereign issuer per se, this stratospheric growth propels the EC into operating like a national debt office and, for traders and investors, places its bonds in the realm of government debt.
“It was by no means obvious that we’d go from issuing €500 million of bonds in 2019 to the €39.5 billion we issued in 2020,” says Bohan. “What made such a programme possible for a then small house like us is that fact that this is an issuance programme with a story and a purpose, designed to pay for an economic and social recovery from an unprecedented crisis. That really mobilised investors.”
But as the global Covid rout continued, a further €50 billion in bonds was issued under the SURE programme the following year, making the Commission the world’s largest social bond issuer.
It was obvious to the Commission that a different funding strategy would be required to address the sheer scale of member states’ needs.
Before 2020, we were coming from a scale of very small issuance, issuing around €500 million of bonds in 2019. We’re now operating at a completely different scale of activity
Niall Bohan, European Commission
Following a five-day “marathon” discussion of the European Council in July 2020, the NGEU was created – with the herculean challenge of launching a debt-funded recovery programme of unprecedented proportions.
The Commission quickly developed a diversified funding strategy of EU bond and bill issuances via auctions and syndications to finance the programme – a completely new funding strategy for the Commission and one typically seen from traditional sovereign debt issuers.
As part of this framework, the Commission set up a network of primary dealers to help distribute the EU’s debt to investors.
The Commission adopted eligibility criteria for primary dealers in April 2021 and by May had on-boarded 39 banks – Barclays, Citi, Deutsche Bank, and Goldman Sachs among them. By the autumn of 2021, a total of 42 banks had applied.
“We didn’t have a specific number in mind. We just wanted to have an open architecture so that anyone who is a primary dealer for an EU sovereign could apply for membership of our primary dealer network,” says Siegfried Ruhl, former head of funding and investor relations at the European Stability Mechanism.
“Dealers do need to meet certain additional criteria to justify their participation in auctions and syndications,” says Ruhl, who in September 2020 joined the European Commission as hors classe adviser in the directorate-general for budget to help roll out NGEU. “We want to be assured that banks have the infrastructure and know-how to deal with such transactions,” he adds.
Getting off the ground
One hurdle facing the Commission to get NGEU off the ground was devising a cost methodology for the corresponding loans that member states would be comfortable with. This resulted in the April publication of an 11-page blueprint that served as the supranational’s battleplan.
Under NGEU, the Commission essentially establishes a loan agreement with each member state, with a linear amortisation of the principal amount from year 10 to year 30. The cost of each loan is fixed and is funded by EU bonds, issued within a sixth month period. The average cost of issuance for that capital then forms the basis of what the Commission charges member states for their loans.
This battleplan allowed the Commission to complete its first NGEU transaction on June 15, 2021, in the form of a €20 billion 10-year bond. In this one transaction, the EU oversaw the largest ever institutional bond issuance in Europe, the largest ever institutional single-tranche transaction and the largest amount the EU had ever raised in a single transaction.
The Commission also saw its first auction of EU bills on September 15 of 2021, raising €5 billion in the process. EU bills are securities with a short-term maturity of less than one year, which serve a critical function in NGEU by allowing the Commission to match member state disbursements with available funds – meaning it always has cash on hand to weather any temporary market disturbances.
An additional aspect to NGEU is the Commission’s ambition to finance around €250 billion through green bond issuance – some 30% of the programme’s total financing – making it the world’s largest green bond issuer. The Commission made its first transaction on October 12, 2021, when it successfully raised €12 billion through a 15-year green bond – a transaction that was almost 12 times oversubscribed with an order book exceeding €135 billion.
“It’s our determination to build on that first transaction and have a pipeline of green bond transactions over the coming years so that the climate transition will be at the heart of this programme,” says Bohan. “We think we’ll have the quantum of expenditure to back-up a fully developed and liquid green bond curve over the next couple of years – that’s our ambition.”
In all, since June 2021, the European Commission has raised €71 billion for NGEU via long-term EU bonds and currently has €20 billion in EU bills outstanding. Such issuance has allowed the Commission to pay €54.15 billion to member states in the forms of loans and grants while an additional €6 billion has been given to other EU programmes that benefit from NGEU funding – fully addressing all payment requests in 2021 according to the Commission.
It’s been a steep learning curve.
“I think you could characterise the whole experience as building a car while driving it,” says Bohan. “It was intense, but we got there in the end and have shown that the market is ready for what we’re aiming to do.”
With an average debt issuance of €150 billion a year, the NGEU programme will likely see the EU become one of the biggest euro debt issuers. The supranational is already planning to issue €50 billion of long-term bonds between January and June this year, along with EU bills to help fund the next round of NGEU support to member states, spurring many investors to view the EU as an attractive alternative to traditional sovereign issuers.
“Of course, by legal nature we are a supranational issuer,” says Ruhl. “But using auctions, having transparent communication, and the volumes involved in our NGEU programme means we are using similar instruments to large sovereign issuers.”
“As a result of having more auctions we’re also seeing higher secondary market liquidity, as there’s always an injection of new bonds. All of that makes investors view us as an enrichment for the market of highly-rated sovereign bonds in the euro market,” Ruhl adds.
The Commission’s SURE programme is funded by issuing up to €100 billion worth of social bonds – instruments that raise money for projects with positive social outcomes - with an average maturity of 15 years, utilising the EU’s credit rating as a triple-A issuer to obtain low interest rates. It then lends the proceeds of those bonds to member states under the same conditions that the money was borrowed – with these loans being used to fund short-term work schemes to protect workers against the risk of unemployment and loss of income.
Proposed in April 2020 and live by September, by the end of 2020, €39.5 billion worth of bonds had been issued to finance the programme.
While SURE utilises a funding model already familiar to the Commission in other programmes, it’s a model that had to be quickly turbo-charged to pave the way for the programme’s first social bond transaction of €17 billion on 20 October 2020. It was more than 13 times oversubscribed, with €233 billion of interest, making it the biggest order book for a bond transaction ever recorded.
The NGEU programme isn’t without its hurdles – particularly when it comes to funding NGEU loans.
As loans are funded against a pool of bond issuance within a six-month period in which the loan was disbursed, there is always the possibility that a bond in this basket matures before the loan. That bond would need replacing by a new bond with the same or similar maturity. But the new bond will have a different interest rate, meaning the average rate of the basket will change – and thus the interest rate on the loan will change.
“So there is a slight interest rate adjustment at the margins every so often when an instrument comes to maturity,” says Bohan.
While such interest rate risk is likely to be limited, the Commission will examine the case for using interest rate swaps to hedge this risk on future loans to member states. The first step would be to discuss with member state recipients the extent to which such a hedging solution might be useful for them.
“It’s something we discussed internally in April 2021 when we published our blueprint,” says Ruhl. “Derivatives are a potential tool to manage the interest rate risk of the loan aspect of NGEU and we would use [them] only if requested by member states.”
The first possible interest rate adjustment might occur when the first bond matures – currently a five-year bond maturing in 2026.
But the EC says existing regulation does not foresee any additional use-cases for derivatives, such as hedging interest rate risk on its bond portfolio, as some sovereign debt management offices do.
The Commission’s portfolio, like its member states, is united in its diversity.
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