Determinants of Spreads on European Supranational Debt: Towards a Genuine European Safe Asset?

A genuine European safe asset would be an essential element of a well-functioning EU capital market needed to support EU growth. To shed light on a feasible path towards such an asset, this paper explores the determinants of yield spreads (relative to German bunds) on sovereign and supranational debt, the latter being the debt issued by the ESM, EIB and the EU itself. We deploy proprietary data from the European System of Central Banks (ESCB) on holdings of individual issuers for monetary policy purposes. We discipline the empirical analysis with a simple portfolio balance model, allowing for default and liquidity risk to affect the pay-off distribution. The empirical effects of outstanding debt (the supply-side), ESCB holdings (the demand-side), bond market and asset-specific volatility are quite well in line with the predictions derived from our portfolio balance model. Increases in ESCB holdings of supranational and high-rated sovereign debt push up their spreads, suggesting that the liquidity effect from a reduced free float dominates the reduced default risk. Further, the findings indicate that supranational debt competes with high-rated sovereign debt in investor portfolios, suggesting that the path towards a genuine European safe asset will at best be a slow one resulting from supranational debt gradually expanding its share in investor portfolios. The creation of a genuine European safe asset could be catalyzed through an increase in EU-level investments financed with an expansion of EU debt and backed by an enlarged EU budget with EU own resources.