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Poisoned panacea

5 June 2012 By Robert Cole

Euro bonds look like such a pleasant panacea. Overstretched sovereign borrowers in the periphery would love them, of course, but they might appeal to fixed income investors too – at least superficially. Nasty Greek and Greek-like risks might be diffused and yields might be more generous. Thomson Reuters data shows that today’s GDP-weighted amalgam yield on 10-year euro zone bonds is about 4 percent. That’s more than double the yield on UK gilts, U.S. Treasuries and German bunds.

Of course, no such bonds exist yet, and their structure is highly uncertain. But whatever their final form, potential buyers are likely to have doubts. Unless the euro zone suddenly becomes more unified, the euro bonds, unlike U.S. Treasuries and UK gilts, would not have the backing of a single clear sovereign government. The risks of weaker euro zone members causing a value-destroying crisis would remain and the euro bond contracts would probably be complicated. Investors will hope that Berlin and its hard money stands behind the regional paper, but that will be more of a hope than a certainty. In practice they’ll hardly know what policies they are buying into.

Ironically, investors could suffer if the euro bonds work too well. Suppose they do what they are supposed to – cure the single currency’s funding problem and spur a new round of economic growth. In a healthier economic environment, inflation might be higher and investors would be less desperate for the safety of solid sovereigns. Bond yields could rise.  A return to the average pre-euro GDP-weighted yield in the ten years up to 1999 would take the 10-year yield to 7 percent, Thomson Reuters data shows. But even a rise from 4 to 5 percent translates into an 8 percent loss of capital value.

Public debate about euro bonds tends to focus on whether new fangled euro bonds can be made to work – politically and economically – for issuers.  For the moment the sceptics have the upper hand. If those doubts are overcome, there will also be some sceptical investors to persuade.


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