International -- Finance: Markets
Bond Bummer in the Euro Zone? (int'l edition)
Aggressive government debt reduction worries investors
Bond markets usually love it when governments behave well. But not these days. Contrary to expectations, most European finance ministers have promised to use a $100 billion windfall from selling mobile-phone licenses this year to reduce debt rather than cut taxes or hike public spending. Bond investors, however, are anything but pleased. Could it be they're overreacting?
Their reasoning is simple. Aggressive debt reduction will create a shortage of government bonds. That in turn will push down returns, and widen the spreads between government and corporate bonds. Analysts now expect that euro-zone governments will raise just $230 billion in the capital markets this year vs. the $330 billion they originally figured they'd need.LICENSE LUCRE. Institutions that buy a lot of government bonds--such as German insurers--are particularly concerned, since their performance will slip as returns on government paper fall. Companies planning to issue bonds also worry that a dearth of government securities could stunt the growth of Europe's fledgling corporate debt market, making it harder for them to raise money.
Nonetheless, most European finance ministers seem determined to pay down debt. Germany's Hans Eichel plans to use his windfall to lop more than $52 billion off the country's $1.1 trillion debt. Italy says it has earmarked half of its license revenues, expected to top $27 billion, for that purpose. France, however, will put the money into its national pension fund.
Debt reduction could continue after the cash from this year's license sales is spent. Thanks to their current economic upswing, Germany, France, and even Italy could have sustainable budget surpluses of as much as 2.5% of gross domestic product by 2003, if not earlier.
Government buybacks elsewhere have affected the bond markets. Investors' return on Swedish government bonds, for example, fell by 0.3% on May 15 after Stockholm unveiled plans to eliminate 8% of public debt. For the first time ever, the returns are lower than those on German government bonds--or Bunds as they are known. Debt reduction programs in the U.S. and Britain have pushed down yields and widened spreads, making life difficult for portfolio managers. "Their returns are under real pressure," says Simon Ballard, a bond strategist at BNP Paribas in London. "Investors now fear the same thing will happen in the euro zone."
Maybe. But there are important differences between the U.S. and British markets and those of the euro zone. For starters, foreign investors don't play as big a role in Europe as they do in the U.S., so euro markets are less volatile. Then there's the fact that the spreads between the different countries' bonds have been stable since the launch of the euro in January, 1999. Analysts say they aren't likely to change much as the debt is reduced. That's because all euro-zone government bonds are denominated in euros, allowing investors to move back and forth among them to exploit differentials.
Nor is there really a government bond benchmark in Europe. German Bunds have pride of place. But for all practical purposes, the real benchmark is the swap rate, which is based on the rate that top banks charge each other for short-term loans. The swap market won't be as responsive to government buybacks as Bunds would be.
So instead of hurting the corporate bond market, government buybacks might actually help it. "If anything, the diminishing supply of government debt should spur the growth of the corporate bond market because investors will have to look for alternatives," says Martin Bayntun, a bond strategist at Gartmore Investment Management in London. What's more, European governments want to avoid roiling the markets. So they are likely to bring more new issues to market than many analysts expect. That's especially true of Eichel, who is expected to stick to his $135 billion issuance calendar for the year. Maybe European investors can learn to live with their governments' newfound rectitude after all.By David Fairlamb in Frankfurt