Fisher Investments Editorial Staff
Others

Circling the Wagons

By, 01/12/2011
Story Highlights:
  • The €440 billion EFSF issued its first bonds to aid Ireland last week.
  • Demand was strong, and Japan threw its hat in the ring for 20% of another issue later this month.
  • EFSF bonds are jointly backed by the eurozone—something that's never happened before.
  • There is no true "EU bond" right now, but EFSF bonds may serve as a prototype. Another sign that, instead splitting apart, the eurozone may become even more tightly connected—at least for now.

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The European Financial Stability Facility (EFSF) is a €440 billion special purpose vehicle created back in May 2010 to fiscally back peripheral eurozone governments. The fund remained untapped until Ireland asked for assistance at the end of last year. Now, the EFSF is auctioning bonds to pay its portion of Ireland's bailout. The first auction went ahead last Wednesday. €5 billion of 5-year debt was sold at a yield of 2.59% (73 bps above comparable German bunds).

What are the prospects for issuance? Pretty good actually. The sale was roughly four times oversubscribed. And today, Japan announced it wanted in on the deal—promising to use €1 billion in foreign reserves to purchase 20% of the next issue. Some headlines credited the announcement for an up day in Europe—markets were encouraged by Japan's support of the eurozone. 

But note, the amount itself is paltry—a tiny, tiny fraction of Japan's total euro reserves. And if the first auction tells the tale, the EFSF doesn't need Japan to raise cash. Further, Japan's move is plenty selfish. Governments (like Japan) are incented to hold foreign exchange reserves in EFSF bonds because the bonds carry a similar risk profile to German bunds—but offer a higher yield. And that's the interesting part.

To begin with, a bond worthy of (and desired for) foreign reserves investment can tap a rather large market. That's good news for future auctions and the eurozone's ability to support the periphery. But what underpins the bond's high quality is even more interesting. The eurozone jointly backs EFSF bonds—and that's never happened before. The European Central Bank controls monetary policy for the entire eurozone, but cash-raising and fiscal matters are strictly domestic—and at the root of the euro's recent troubles.

An EU bond would be a step, largely unforeseen a year ago, towards fiscal federalism.  And while there is no true "EU bond" right now, EFSF bonds may serve as a prototype. If EFSF bonds prove successful, they may soften opposition to an EU-wide debt security. Another sign that, instead of splitting apart, the eurozone may become even more tightly connected—at least for now.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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