„Secure government bonds“ – Brussels betting on the wrong horse

As the saying goes, there’s life in the old dog yet. This also applies to the European Safe Bonds (ESBies) concept. Let us cast our minds back: Brunnermeier et alia first presented their idea of structured bonds in 2016, the objective being to remedy the lack of „safe“ government bonds in the euro zone and at the same time counteract the nexus between state and banks which had become a problem, especially in the periphery. Special purpose vehicles were to be created for this purpose so that euro zone government bonds could be purchased and financed by issuing at least two different tranches of structured bonds – most notably safe senior bonds which would be of particular interest to banks, and higher-interest junior tranches. The idea behind this was that any defaults on government bonds would be initially fully borne by the holders of the junior tranches; only after a specific loss threshold had been violated would the holders of the senior bonds incur losses. By allotting about 70% of the ESBies to the senior tranche, the volume of safe government bonds in the euro zone could be significantly raised – at least that was the idea.

The European Commission has now prepared a legislative framework for Sovereign Bond-backed Securities (SBBS) which is to be presented next week and is based on the ESBies concept. The Commission’s key objective is to have banks diversify their bond holdings more geographically. The Commission also defends the allegation that SBBS are ultimately modified Eurobonds.

The EU is right in this respect. SBBS or ESBies do not pursue the goal of allowing states to collectively refinance their borrowings. Nevertheless, Brussels is betting on the wrong horse. The concept has already been judged by various parties to be poorly conceived and unsuitable in terms of its intended goal. A study by DZ BANK from February last year entitled „ESBies – no cure-all remedy“ already came to the conclusion that the concept would probably fail to achieve the desired goals. Particularly in times of crisis, there is a risk that the value of senior bonds will also fall significantly and thus by no means deserve the claim of being an adequate replacement for German government bonds. By the time S&P had published an assessment in May 2017 which claimed that even the senior tranches, depending on their structure, could expect at most a rating equivalent to Italy’s credit rating, most market players thought that the concept had been shelved once and for all. This may also explain why no ESBies have been issued so far although banks or other private institutions could already offer them under the current legal framework.

This makes the EU Commission’s current initiative all the more astonishing. Given the limited market interest so far, the Commission ought to be keen to create incentives to help the bonds, then trading under SBBS, to achieve the breakthrough. Given the conceptual weaknesses of the underlying idea, investor demand is likely to remain subdued. If, however, the Commission still succeeds in establishing SBBS on the market, it would probably achieve the opposite of what it actually intends and create new potential threats to the stability of the European financial system. It would be better if the countries were to continue pressing ahead with their reform efforts which really would improve the safety and, by extension, quality of government bonds per se.

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