A European safe asset? Not without the investors

We study bonds issued by the European Union (EU) as joint and several liabilities of its member countries and show that they pay higher interest rates than comparably safe and large sovereign issuers. The spread reflects their greater sensitivity to adverse market shocks, which becomes particularly pronounced during periods of monetary tightening. Using novel data, we document that EU bonds have a small investor base because they are excluded from the main fixed-income indices due to their lack of formal sovereign status. This exclusion lowers expected prices during crises, making EU bonds unattractive to investors with liquidity needs, such as mutual funds and foreign central banks. Expectations of state-contingent purchases by the European Central Bank (ECB) can compress this premium considerably even when they are not directed at EU bonds. A demand-based asset pricing framework suggests that the spread would be negligible if the EU were recognized as a fully sovereign issuer and there would be a new safe asset.