Back-to-Basics: The Euro and the Bond Markets

Teri Geske
Senior Vice President, Product Development

First, some terminology and background. The Euro is now the common currency of the countries participating in Europe's Economic and Monetary Union, EMU. The current member countries are: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain; others including the U.K., Denmark and Sweden may join at a later date. Countries had to meet certain requirements regarding budget deficits, inflation targets and government borrowings as a percent of GDP to become members. Monetary policy for "Euroland" or "the Euro Zone" (names now used to describe the EMU member countries) will be set by the newly-created European Central Bank headquartered in Frankfurt.

Over the New Year weekend (or "Le Weekend," as it has been dubbed), all outstanding government bonds (approximately 1,100) issued by EMU member nations were "redenominated" into Euros, along with about 24,000 corporate bonds. Stock exchanges of the member countries now quote and settle trades in Euros. For the next few years, electronic banking and other transactions may be done in either the Euro or the underlying currencies (deutsche marks, francs, lira, etc.,). If all goes as planned, on January 1, 2002, Euro bills and coins will be introduced into circulation and on July 1, 2002, the national currencies of EMU members will cease to be legal tender.

The introduction of the Euro has many far-reaching implications. It creates a market that is slightly larger than the U.S. in population with a GDP roughly 80% of the U.S GDP (in 1997 dollars). Euroland has a combined government bond market that is about 20% bigger than the U.S. Treasury market and a corporate bond market roughly two-thirds the size of the U.S. market. Exchange rates between the Euro and the national currencies of the EMU countries have been irrevocably fixed, thus eliminating all exchange rate risk across member countries. For example, one Euro = 6.55957 French francs, 1.95583 German marks or 1,936.27 Italian lira, regardless of currency fluctuations between the Euro and non-EMU countries. Therefore, at least in theory, businesses and consumers in Euroland should be much more willing to buy, sell, borrow and invest across borders as the financial uncertainty and logistical hassles associated with exchanging currencies disappear. (Some argue that a fairly immediate result will be an end to the often large price differences across EMU countries that were previously masked by currency fluctuations. Now, a pair of Nike tennis shoes or a box of Kleenex should cost approximately the same from one country to the next, as quoting in Euros makes it much easier for customers to "comparison shop" across borders, although taxes and differences in labor costs will cause some prices differences to persist.)

What does this mean for fixed income markets in the EMU member countries? Since there is no longer any risk of adverse exchange rate movements among EMU countries, any differences in yields would reflect the market's perception of the relative creditworthiness of each sovereign government1. For example, if the 2-year German government bond yield is 3.25% and the 2-year Italian government bond yield is 3.40%, this would indicate that the market views the Italian bond as involving relatively more credit risk than the German bond (if the credit risk were perceived to be identical, investors would sell the German bond and buy the Italian bond until the yields on the two were identical). Therefore, assuming investors believe that the differences in sovereign credit risk are fairly small, we would expect government bond yields in the EMU countries to converge and in fact this has occurred to a great extent.

The Corporate bond market is likely to grow significantly as a result of the Euro. Up until now, European companies have tended to rely on bank debt as their primary source of borrowing. This is due at least in part to the fragmented nature of the European market. Germany, the largest EMU country, is only about 25% the size of the U.S. in terms of GDP. Before the Euro, the decision to invest in a corporate bond issued by a foreign corporation and denominated in another currency, required not only an analysis of the credit quality of the issuer but also a view on whether or not to hedge the currency risk. This tended to limit the potential investor base for the corporate bonds of any single European country, which in turn prompted many European companies to issue debt denominated in U.S. dollars, tapping into the U.S. investor base which is many times larger than that of any individual EMU member nation. Regulatory restrictions had also discouraged cross-border investing in Europe. For example, prior to the Euro, insurance companies in France had to invest at least 80% of their assets in the domestic market. These insurance companies can now invest throughout the Euro Zone and represent a new, potentially large investor base for corporate issuers in other EMU member countries. All of these factors should expand the investor base for corporate bonds in the Euro Zone, and may provide incentives for companies to issue bonds denominated in Euros, rather than in U.S. dollars, particularly if their revenues are primarily derived from EMU countries.

For U.S.-based investors, a unified European debt market denominated in a single currency represents an opportunity to diversify fixed income portfolio holdings into non-U.S. credits with a greatly simplified currency management process. With the Euro, currency fluctuations across EMU countries have been eliminated, so the decision to invest in corporate debt issued by a Euroland-based corporation will now be based on credit analysis. While European investors have traditionally focused on currency risk when constructing fixed income portfolios, bond managers in the U.S. are accustomed to evaluating credit risk when making investment decisions.

The Euro in BondEdge: BondEdge's Multi-Currency module was released last year. This system allows you to create non-U.S. dollar securities, to report on your portfolios’ exposure to different countries and currencies, and to incorporate currency Forward Rate Agreements as a hedge, if desired. The Euro has been added to the module's Currency Matrix and the U.S. dollar/Euro exchange rate is updated daily. You can model non-dollar bonds that pay in Euros or in the legacy currencies (Interactive Data Fixed Income Analytics will continue to update the U.S. dollar exchanges rates with the national currencies of the EMU countries until those currencies are no longer in circulation). If you would like more information about the Multi-Currency module, please contact your Interactive Data Fixed Income Analytics representative. Some of the bond index providers have announced they will be creating one or more Euro indices to provide portfolio managers with a benchmark for this new market. If you would like Interactive Data Fixed Income Analytics to model any of these indices, please let us know as we are planning a number of enhancements to the Multi-Currency module in BondEdge in the Fall of 1999. If you have any comments or questions about this, or if you have suggestions for other "Back-to-Basics" topics, please contact marketing at (310) 479-9715 or via email, fia.marketing@interactivedata.com.

¹ For a brief review of forward exchange rates and interest rate parity, please see the previous "Back-to-Basics" article titled "Non-U.S. Dollar Investments and Hedging Exchange Rate Risk."