Considering the degree to which global investors and central bankers are moving into uncharted territory, there is a high level of confidence about the new 'euro' bond market. Currency convergence has been a gradual process and the differential has not been an issue for 18 months. For investors in the new euro papers, the main thing to be assessed will be credit risk.
It's really amazing how many things we still don't know, for something that is starting in three weeks' time," was the view of Merrill Lynch's chief fixed income strategist Cesar Molinas in mid-December. "Although we have some idea, we don't actually know what the coupon will be for ECB bonds or what benchmarks will be used. How will an Italian investor price a particular credit in relation to their own credits. And how will a German price the same credit?"
The euro bond rate will effectively be a combination of euro treasury yields, where currently 10-year German bunds are at 3.80%, 10-year French government paper at 3.86% and 10-year Italian paper at 4%.
Currency and bond expert Howard Flight suggests that 'euro' bonds will be particularly attractive, combining high real rates of interest with a strong currency: "There will be problems with small outstanding fractions on conversion of bond denominations, where different states are following slightly different formulae, but financial regulations will require precise allocations to underlying fund shareholders."
Despite all this, however, Flight's view is that the euro may become too strong over the next two years, costing millions of jobs. This will be exacerbated by a growing conflict between the German government and ECB.
This point is echoed by Peter Toogood at Forsyth Partners: "The political risks have increased with 'Red Oskar's' [German finance minister Oskar_LaFontaine] protestations which are likely to generate a belligerent attitude from the ECB." Furthermore, Flight says high taxes and the strong currency will be bad for growth and as a result, equities are likely to disappoint.
In bond management, the focus will be on managing credit risk and duration.
Molinas notes that radical change has already happened: "The key driver for bond valuations in the euro- zone will be government involvement and ownership changes in the structure of industries." It is also expected that inflation will be relatively low over the next five-10 years, forcing fund managers to seek new sources of yield. The development of high yield bonds, hedge funds and private equity funds may be fuelled in part by this.
It is anticipated, however, that Europe will be relatively slow to develop a US degree of sophistication in its bond market. Amongst other things, credit spread analysis may be relatively difficult, owing to the less transparent nature of European financial information.
Paul Thursby at Baring Asset Management says, "We are always wary of something new but the Euro looks like being a strong stable currency, which will complement the dollar. It just becomes another grouping, making up probably 20% of a global weighting. The big question is when the problems start to arise over credit risk and to what extent investors are happy to invest outside the eurozone."
Security of the euro bond zone has been called into question by some experts who point out that, as a German investor, you've still go a German government guarantee underlying the bond and as such it will have all the hallmarks of a German bund. But there is no defined 'lender if last resort'.
Molinas says, "One thing is clear, the ECB is not a lender of last resort, but perhaps it's an exaggeration to say there is not one; there may indeed be too many. The banking system is not yet pan-European, so each country's central bank has that role, under the coordination of the ECB.
"Then the risk is how swift will the ECB act in addressing an emergency situation, which may well require pan-European coordination. For example, you have German banks with exposure to eastern Europe and Spanish banks exposed to Latin America and derivatives, so the structure of the banks is still heterogeneous and will remain so for a number of years."
Thursby is concerned about the countries' ability to reach agreement on setting rates: "Policy is supposed to be via consensus, so we are interested to see how they are going to react if it means hurting their own country. One of the challenges for Europe is if Italy is moving out of line, whether you are going to tighten in Germany for the good of Europe as a whole."
Finally, there is the issue of the proposed tax harmonisation for Europe, which cannot be ignored in any assessment of euroland. And specifically, the proposed common withholding tax. If this does proceed, says Flight, "it may be that we will all be looking at euro-denominated bonds, issued for European borrowers, but from locations outside the EU in order to avoid the common withholding tax on interest payments.""