The global economy is strongly dependent on how the debt markets evolve. Governments, as well as corporations, issue debt for various reasons – to fund large infrastructure investments or expansion plans.
There is no doubt in the investment world that debt markets facilitate economic growth, even though concerns have been raised in the last few years that most of the newly issued debt typically goes to cover a trade deficit.
Running a trade deficit is not a bad thing, as long as the government has the ability to sustain it. 2020 brought massive government intervention in the fiscal and monetary space. While central banks in the developed world are independent, they do act as a bank for the government, so the two institutions should be viewed as interdependent.
EU Recovery Fund Had a Positive Impact on EU Government Bonds
When looking at credit-related risk, investors consider the following – market liquidity, downgrade risk, and spread risk. Out of the three, the spread risk is of particular importance. It is mostly interpreted in the corporate world due to corporate bonds being interpreted as riskier than government ones. As such, the higher spread when compared to a benchmark denotes the risk of the bond.
A similar analysis is made when comparing sovereign bonds. Italy and Spain have long been troubled economies in the Euro area, and the spread, or difference, between the 10y Italian and Spanish yields versus the German bund over a similar period is often viewed as the credit risk benchmark for Europe. For example, during the 2008-2009 Great Financial Crisis or during the 2012 sovereign crisis caused by the Greek debt problems, the spreads increased when compared to the benchmark, making it difficult for the two countries to tap financial markets for more funding.
Why would yields increase or decrease, thus changing the risk of a bond? The answer comes from creditworthiness. The higher, the lower the yield and the risk. The lower, the higher the yield and the risk.
2020 saw Europe coming together when it comes to a common reaction to the funding needs generated by the COVID-19 pandemic. The EU Recovery Fund had an immediate impact on government bonds, sending the yields of Spain’s 10yr bonds hit negative toward the end of the year.
From the moment the EU announced the Recovery Fund, the spreads with the German bunds dropped significantly. As such, Europe has gained investor’s trust and has access to very cheap credit terms in international financial markets – a positive for the European economies struggling with the coronavirus-led recession.