Europe’s New Common Bonds Prove a Hit With Investors

The new bonds could help narrow the gap in borrowing costs between countries such as Germany and Italy. The EU bonds will likely divert demand away from German bonds, until now Europe’s key benchmark risk-free asset, while also boosting the Italian economy, according to some investors and analysts. A large gap in borrowing costs is seen by investors as a sign of financial stress in the region.

While the U.S. has spent trillions of dollars on stimulus checks and unemployment benefits to carry the economy through the pandemic, Europe has been slower to get its act together, hamstrung in part by the conservative economic attitudes among many northern states and political dysfunction and weak economies in some southern states.

The European Union’s nearly €800 billion recovery plan should start to turn the tide. It is the first major pan-European debt issuance program collectively backed by all the member states. The stronger economies, such as Germany and the Netherlands, are in effect lending the strength of their balance sheets to help fund recovery efforts in the weaker south.

“It will be a key support for the economic recovery as the continent emerges from the pandemic,” said

Dean Turner,

an economist in

UBS’s

Global Wealth Management business.

The EU is expected to start distributing the money over the summer and the spending will be equivalent 0.7% of European gross domestic product this year, rising to 1.2% to 1.3% for each of the next three years, Mr. Turner said.

As well as helping to fund the recovery, the triple-A-rated EU bonds will also help to alleviate a shortage of safe assets, which is one of the reasons that German bonds trade at such deeply negative yields, according to Oliver Brennan, head of research at TS Lombard.

There are only about €2.2 trillion worth of German government bonds outstanding and more than two thirds of those are owned by the European Central Bank and other central banks or foreign reserve managers, leaving just a few hundred billion euros’ worth for all other institutions to buy, according to Mr. Brennan.

But from 2022 onward, the EU recovery fund will likely become the largest source of new bonds, selling roughly €150 billion each year, overtaking Germany, France and Italy.

“The recovery fund will ease the safe-asset shortage by offering an alternative home for foreign reserve managers,” Mr. Brennan said. The amount of German bonds available for other investors to buy will slowly increase and their yields will begin to rise, he added.

The moves are nascent so far, but since the EU issuance, German 10-year bond yields have risen to minus 0.215% from minus 0.270%, while the EU bond yields fell as low as 0.03% this week from 0.086%, according to Tradeweb. The EU bonds sold off slightly in line with the rest of the European government bond market on Friday.

More of the recovery fund will be spent on countries like Italy and Spain, where the pandemic has dealt a heavier blow than in countries like France and Germany. Italy is expected to receive more than 25% of the funds, while Germany will get less than 5%.

“Germany is one of the largest net contributors to the fund, while Italy is one of the largest net recipients,” Mr. Brennan said.

He recommends buying Italian bonds versus German bonds to bet on a narrowing of the spread—the difference in yields between the two.

That difference is currently about 1.05 percentage points for 10-year bonds, close to a recent low set in mid-February. The gap was as large as 3.2 percentage points in November 2018 and more than 5.3 percentage points during the worst phase of the eurozone debt crisis in 2012.

Before 2008, the gap was typically less than 0.3 percentage point, according to Tradeweb.

Write to Paul J. Davies at paul.davies@wsj.com