EU bonds pay premium due to legal status, small investor base
A Banca d'Italia Occasional Paper finds that European Union bonds pay higher interest rates than comparable sovereign issuers. This premium reflects their exclusion from fixed-income indices due to a lack of formal sovereign status, limiting their investor base.
The legal status premium
European Union bonds, despite their AAA rating and significant outstanding volume of over €1.6 trillion, trade at a substantial premium of around 50 basis points compared to sovereign debt.
This phenomenon is not attributable to perceived credit risk, which credit default swaps show to be up to ten times smaller than the observed spread.
Instead, the paper argues this premium stems from their legal status as "supranationals," which excludes them from major fixed-income indices.
This exclusion dramatically shrinks their potential investor base, making them less attractive to institutional investors, particularly those with liquidity needs, as prices fall more sharply during market crises.
This finding extends to all supranationals, regardless of their activity or credit backing, including bonds issued by KfW.
Investor base and conditional QE
The study introduces a novel measure quantifying the potential investor base, revealing that EU bonds and other supranationals have a benchmarked investor base only about 20% the size of comparable sovereign bonds.
This "inelastic demand" leads to higher borrowing costs.
Investors with liquidity needs, such as mutual funds and foreign central banks, largely avoid these bonds due to their greater price sensitivity during market stress.
Conversely, insurance companies and commercial banks, with their stable liabilities, are natural buyers but are insufficient to absorb the supply, allowing the spread to persist.
The paper also develops a model showing that expectations of future central bank support, termed "conditional QE," can significantly compress this premium, even when no program is currently active.
Legal status, not fragmentation, is the issue
This research decisively refutes the notion that the "EU premium" is a consequence of political fragmentation, instead pinpointing the legal status of EU bonds as the primary driver.
It underscores the ineffectiveness of policies that fail to address the fundamental problem of inelastic demand and index exclusion.
Ultimately, the study suggests that recognizing the European Commission as a fully sovereign entity would be the most impactful solution for establishing a true European safe asset.