The secret of our success
That dream has come true in less than a decade. The euro bond market has indeed grown in size and depth to an equivalent of the US market. Yet, in many respects that market is at present different and will keep in the future its own roots and peculiarities. The very forces behind this success, political willingness to achieve a common currency and the momentum of market participants will not erase those differences, which in reality are simply part of its identity.
History will certainly consider 1999 as a milestone in European integration as well as in financial market development. This event had been well prepared both on the macroeconomic side with the discipline set by the famous Maastricht treaty criteria and on the financial market side with the convergence in the European capital markets. A single currency is without doubt a true symbol, but above all it is a very pragmatic and efficient decision fostering the European economic integration. No more tedious currency conversion, no more uncertainty, no more collecting different coins and banks notes in people’s wallets: everyone can enjoy the benefit of the single currency with the exception of the currency traders themselves. Furthermore the bond markets were scattered across various domestic markets with low liquidity and cumbersome differences in administrative rules. By anchoring the future currency to the Deutsche Mark through policies like the ‘Franc fort’ policy achieved by Jean-Claude Trichet, the expected benefits have outpaced the short-term pain and discipline inflicted on some economic agents. Indeed as Figure 2 shows, the convergence of yield has been towards the lowest, for the benefit of the borrowers in the economy and – with the lowest inflation for the benefit of the investors.
Convergence plays were very popular at the end of the 1990s and have emphasised one of the peculiarities of the euro bond market: in contrast to the US market, several governments are issuing debt. If German bonds offer the lowest yield on 10-year maturities, it doesn’t mean that all government issues from other countries will exhibit the same yield, nor that German bonds of other maturities are necessarily the most expensive. Reference yield curve therefore becomes more problematic. Market players did not take long to find the swap curve as the focal yield, if not the lowest, since swap rates are standardised and the market is very liquid. Recent BIS figures show that it is the largest derivative market in the world. It was used as a proxy when the markets were not integrated, and is now the liquidity attractor of the market. That may be one of the reasons why the swap spread is so low in the euro market compared with the US market, and renders the euro very unique as long as the government bonds remain fragmented. Doomsayers predicted disruption or instability which did not occur. Sceptics, three years later, predicted the failure of the euro as a currency, with fake money pouring into European wallets or a shortage of banknotes in ATMs. Let’s instead enjoy the success of the euro.
A look at Figure 1, Bond debt in the world, shows immediately the relative size of the euro bond market compared with the American and Asian markets.
At $3,720bn, the market for government bonds in euro is now the market leader, greater that the US MBS market and greater than the JGB market. Nevertheless, other segments of the market remain much less developed – like corporate bonds ($960bn compared with $1,620bn in the US) or, of course, covered bonds. However, as we shall see later, these are the most dynamic parts of the market today. Asia (excluding Japan) remains underdeveloped even if a lot of regional efforts have been made to launch a genuine market, with the euro as an example.
The market growth was fuelled by two key factors – savings and allocation. Europe, especially in the euro zone, enjoys a high savings rate, some 12% in Germany and even higher, 15%, in France, mostly for demographic reasons. In particular, third pillar pension products are popular everywhere, from Italy to Spain, and life insurance products benefit from the cautious stance of baby-boomers towards the existing pension systems that may face difficulties in sustaining the demographic peak. So asset gathering has developed recently at tremendous speed; a double-digit growth in a lacklustre economic environment is something noticeable. On the allocation side, bonds have been the pet investment vehicle for many known reasons. ‘Rentier’ behaviour is embedded in individuals’ minds and conservatism is widespread among professional investors. Moreover, the influence of sound financial management has given a boost to ALM practices, meaning cash flow matching and careful management of the interest rate risks. If, on top of that, you consider the bias in accounting that favours bonds, one clearly understands why bonds are dominant in Continental Europe.
Euro bond markets have shifted remarkably from a country bias to a new segmentation related to bond issuers or to bonds themselves The linker market is one example, with now about e160bn of inflation-linked bonds issued by France, Italy, Greece and Portugal either related to inflation in the Euro-zone or to domestic indices. Corporate market which was existing but was completely illiquid has enjoyed a wonderful growth in size and diversity as the breakdown of high yield outstanding strikingly shows.
This growth benefited from the disintermediation trend in Europe and from the American issuer interest in a large savings pool in Europe. Market participants, banks and investors alike developed their expertise in that area, hiring credit analysts and making use of the latest techniques and derivatives.
Indeed, cash market growth provides the backbone of an impressive derivatives market development. Starting from a very strong base on interest rate derivatives, inflation swaps, CDSs and more sophisticated products based on yield, yield curve and credit have attracted great interest from the investors starving for yield and trying to specialise in order to outperform benchmark and distinguish themselves from the competition. Hedge funds have in that area challenged the traditional long-only managers which, on the other hand, can invest in derivatives in a more transparent and meaningful way thanks to the new UCITs directive.
Innovation occurs in many areas, new trading platforms are commonly used, new indices like iBoxx and iTtrax are very popular and the structured products market - especially the CDO market - is now commonplace, with some European leadership on synthetic CDOs. More recently very-long-term issuance, up to 50 years, by government and corporations, also signalled a sizeable demand coming from long-term investors had to be met.
But sceptics are here to stay and will always find occasions to voice their concerns. Critics start with the political background, saying that there is no face to represent the European government and no single speaker to address the market participants’ concerns on macroeconomic and fiscal policy. The ‘no’ vote in the Dutch and French referendums was another situation whereby the support of the single currency, especially from Italy, was questioned. The ‘drive’ of the euro market has often been debated and some may consider the euro bond market as a follower of the US market. Critics have also expressed their opinions on the cost and transparency of the market. However, according to recent evidence, it seems, on the contrary, that corporate bond bid/ask spreads for instance are lower in the euro market than in other markets.
In many respects, action rather than debate has been the answer to the above critics. On the monetary side, ECB has not been shy to show its difference in attitude and in policy intervention. The obvious result is more than two years of short-term rate stability coinciding with a 3% gradual increase of the Fed.
Political integration is hardly an objective and many wonder if this is a necessity. So the Euro-zone is a different kind of market with several governments issuing in the same single market. Investors have taken note and don’t blindly put every bond into the same bag (see the spread). Harmonising the market practices also became the concern of market players, regrouped in associations like AMTE and the Euro Bond Market Association, that specifically work on covered bond market harmonisation, on putting sound practices for corporate bond issuance, or on developing inflation-linked products. The task is obviously daunting, every aspect of financial life, tax issues, regulatory issues, distribution channel need further integration in order to offer a level playing field.
The future of the euro bond market will undoubtedly be linked to the many challenges of the Euro-zone and the harmonisation the market needs. New entrants from the eastern countries, will bring more diversity in investor base as well as in products. Effort will have to be spent on the regulatory side to harmonise and tailor the appropriate level of detail to the rules (some would say burden). Willingness to integrate, in particular in the retail market, for example, more funds - 26,000 in Europe today - would be welcome.
The trends we have experienced will probably strengthen, in particular specialisation and innovation. This means that asset backed securities (ABS) issuance will continue to grow in volume and sophistication. The derivatives market will contribute and integrate new risks, like environmental risk (CO2, temperature…) or more general risks (mortality, real estate…). The nascent hybrid market will find amateurs and the high yield market will gain in popularity. Will we see more inflation linked? Certainly from the issuers with the best credit quality. Will we see an integrated government market? Not for the near future. That challenge is left for future generations!