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When the European Union began its drive to create the euro in the 1990s, opponents of the single currency embraced the idea of a multispeed Europe, a departure from the bloc’s traditional practice of having every member adopt each of the group’s policies. For euro-skeptic Britons in particular, this differentiated union would enable the U.K. to stay outside the euro area but remain an EU member in good standing, with full access to the bloc’s single market for goods and services.

Today this multispeed Europe is more of a reality than ever, but with a twist. The great distinction is not between the countries that are in or out of the single currency but between the euro area members themselves. Europe’s debt crisis has made sovereign risk the paramount driver of the region’s bond market and has sent yield spreads soaring to levels far above those that prevailed in the days of national currencies. For borrowers with large funding programs, the challenge of securing financing at an acceptable price is greater than ever.

The recent worsening of the crisis, including Portugal’s decision last month to accept a E78 billion ($110 billion) bailout package from the EU and the International Monetary Fund, and mounting speculation about a rescheduling of Greece’s debt just one year after it received E110 billion in assistance, has raised the risks for borrowers and investors alike. The brief respite earlier this year, when spreads narrowed and European policymakers talked as if they had resolved the crisis by agreeing to set up a permanent bailout facility, the European Stability Mechanism, now appears to have been a false, or at least premature, dawn. There are signs of increasing tension in the euro area; comments by German Chancellor Angela Merkel and European Central Bank officials ruling out any Greek debt restructuring sent yields on ten-year Greek government bonds spiking by more than 60 basis points on May

20 alone. Those bonds were yielding 16.76 percent late last month, or 1,392 basis points more than comparable German government bonds, known as Bunds.

In effect, the euro area is now a three-tier market. At the core lies Germany, which sets the European benchmark and enjoys unfettered access to the markets. Yields on ten-year Bunds stood at 3.07 percent late last month, above the 2010 low of 2.7 percent but well below the 4.2 percent level prevailing in May 2007, before the onset of the global financial crisis. A second tier of countries includes core euro members such as France and the Netherlands and non-euro countries like Sweden and the U.K. These states have seen their yields rise relative to Germany’s, but they can still tap the markets freely, even if most have scaled back their borrowing programs as part of an EU-wide drive to reduce budget deficits. France’s ten-year bonds were yielding 38 basis points more than Bunds last month, well above the spread of 2 to 3 basis points that prevailed back in 2006. Last, there are countries like Italy and Spain, which have not had to resort to EU-IMF bailouts but are struggling with heavy debt burdens and sluggish economies. The spread on Spanish ten-year bonds rose to 241 basis points late last month, a near record since the adoption of the euro, while spreads on Italian bonds stood at 170 basis points, up from about 120 back in November.

Spain holds the key to the market outlook because the sheer size of its economy would strain the ability of the EU and IMF to arrange a bailout. The government of Prime Minister José Luis Zapatero has been resolute in slashing its deficit over the past year and trying to strengthen an overstretched banking system through consolidation, insisting that Spain can get its fiscal and economic house in order on its own. Most investors remain fairly optimistic that Madrid will succeed and that Europe will contain the worst of the debt crisis to Greece, Ireland and Portugal. “The market now believes that Spain, which is the country to watch in Europe, will ride this crisis out,” says Chris Iggo, chief investment officer for fixed income at AXA Investment Managers in London.

But market confidence has ebbed since late March, when the governor of the Bank of Spain, Miguel Ángel Fernández Ordóñez, was able to boast about Spain’s declining yield spreads in a speech at the Council on Foreign Relations in New York. The prospect of a Greek rescheduling has heightened nervousness among investors. Moody’s Investors Service warned late last month that such a rescheduling, which it considers tantamount to default, would have potentially severe repercussions for many other EU borrowers, leading to “increasingly polarised sovereign ratings in Europe, with stronger countries retaining high or very high ratings and weaker countries struggling to remain in investment grade.” At the same time, mass protests against Spain’s 21.3 percent unemployment rate and a heavy defeat for the ruling Socialists in municipal and regional elections last month at the hands of the conservative People’s Party have fanned doubts about the country’s willingness to sustain fiscal austerity.

In this environment the Spanish government has had to become more proactive and market-friendly in selling its debt. The Treasury has doubled the number of investor road shows it has held in the past 18 months in a bid to reassure investors that the government is determined to reduce its budget deficit to 3 percent of GDP by 2013 and to implement major banking, pension and labor reforms, according to Ignacio Fernández-Palomero Morales, head of the Treasury’s funding and debt management unit. The Treasury has worked more closely with bankers to identify good windows for issuance and to price its syndicated debt offerings. “There has been much more intense interaction with its bankers this year,” says Rom Balax, deputy head of European public sector syndication at Royal Bank of Scotland Group in London. The Treasury has also stepped up coordination with other European issuers to ensure that there is not an excessive amount of supply in the market at any given time. In January, officials consulted with their Belgian counterparts to make sure the two governments wouldn’t tap the market on the same day. Spain issued a €5 billion ten-year bond issue on January 17, and Belgium followed the next day with a €3 billion ten-year offering.

Spain plans to reduce its net borrowings by 24 percent this year, to €47.2 billion, a trend that reflects its deficit-cutting agenda. The government says it is on target to pare the deficit to 6 percent of GDP this year from 9.2 percent in 2010. The Treasury is continuing to tap the long end of the market, notwithstanding the fact that it pays much higher spreads at those maturities, because officials believe consistency is important and because they don’t want to increase refinancing risk. The government has gradually extended the average maturity of its debt over the past seven years to 6.8 years from five years. The average funding cost for Spain’s debt has risen to 3.85 percent currently from 3.69 percent at the end of 2009.

“There is an unstable situation at the European level, but we can’t make rapid changes to our overall strategy,” says Fernández-Palomero Morales. “We want to be as transparent and predictable as possible. What we have done as of this year is to make monthly announcements about our issuance plans rather than quarterly as before. This makes us more responsive to short-term market conditions.”

Such efforts don’t always succeed. The Treasury last month sold only €724 million of 30-year bonds at auction, about half the amount it had intended to raise, market sources say. The yield on the bonds was 6.002 percent, up from 5.875 percent at the previous 30-year auction, in March. Still, Fernández-Palomero Morales says he was pleased that the Treasury was able to sell €2.5 billion of ten-year bonds the same day at a yield of 5.395 percent, down slightly from 5.472 percent at the previous ten-year sale, in April.

Problems in the euro area’s periphery have made life easier, from a funding perspective, for both core countries and for the U.K. as investors have sought safety in these credits, which are perceived as solid. Although the Dutch government has doubled its annual net borrowing, to nearly €60 billion, since 2008, its fundraising efforts have been “almost boring,” with relatively low yields and good investor demand, says Erik Wilders, head of the Dutch State Treasury Agency in Amsterdam. The ten-year Dutch bond was trading at a yield of 3.36 percent last month, up from the 2010 low of about 2.8 percent but well below the 4.6 percent yield prevailing in the summer of 2007, just before the financial crisis erupted. Dutch paper was trading at a spread of 29 basis points over Bunds, slightly tighter than French bonds.

For some investors, only Germany will do given the risks they see elsewhere. “As the spreads show, German bonds are the assets of choice,” says Thomas Sartain, a fixed-income fund manager at Schroder Investment Management in London. “The traditional government bond investor wants safety.” A slight reduction in the volume of German paper is also helping to bolster the government’s benchmark status. Germany plans to reduce its debt issuance modestly this year, to €302 billion from €312 billion in 2010, as part of its effort to cut the deficit to 2.5 percent of GDP this year from 3.3 percent in 2010. The government aims to eliminate the deficit by 2015.

The German Finance Agency, the Finance Ministry arm that manages the government’s debt, is stressing predictability and consistency in its issuance plans rather than trying to exploit any short-term market opportunities. That approach extends to its offerings of inflation-linked debt. Demand for such paper has increased, reflecting investor concerns about a possible rise in inflation. In April the Finance Agency sold €2.76 billion of bonds maturing in 2018 at a low yield of just 0.83 percent over the rate of inflation. Overall, though, the agency does not plan to increase the amount of inflation-linked issuance this year much beyond the 2010 total of €11 billion.

German agencies are also playing a steady game. KfW Bankengruppe, the state-­guaranteed development bank, did delay a $4 billion three-year global bond issue for two weeks in March because of the Japanese earthquake and tsunami, but it hasn’t altered its funding strategy because of Europe’s debt problems, says Frank Czichowski, the group’s treasurer. As of late May the bank had raised €40 billion of its 2011 target of €75 billion, slightly below last year’s €76 billion total.

One of the biggest benefactors of the European debt crisis is the U.K. The freedom of being outside the euro area and able to issue debt in one’s own currency has rarely felt so good. That’s especially the case for a country that only a year ago was running the third-largest deficit in the EU, behind Ireland and Greece, at 10.4 percent of GDP. Two things have happened since then. First, the coalition government of Prime Minister David Cameron has embraced an austerity program that aims to slash the deficit to 1.5 percent of GDP by 2016 from 11.1 percent in the fiscal year ended in March 2010. That stance has revived market confidence, at least for now. “There has been a fantastic turnaround in the way the U.K. has been seen since the beginning of last year, partly because of efforts to cut public spending and partly because of the transparency of the Debt Management Office,” says Lee Cumbes, head of frequent-borrower debt capital markets at Barclays Capital in London.

Second, the U.K. is benefiting from a flight to safety by investors worried about Europe’s debt sustainability. “There is anecdotal evidence that there has been safe-haven buying of sterling assets,” says Robert Stheeman, CEO of the Debt Management Office. Bankers say much of this safe-haven buying has come from central banks and sovereign wealth funds in Asia and the Middle East. The effect of the inflows has been impressive: The government’s benchmark ten-year bond, or gilt, was trading at a yield of just 3.34 percent late last month, below the 3.7 percent level of a year earlier and down from 4.6 percent in May 2006.

Britain does have an inflation problem, though. Prices are rising at an annual rate of 4.5 percent, more than double the Bank of England’s target of 2 percent. With demand for inflation protection rising, the Debt Management Office plans to issue a record £38 billion of inflation-linked bonds in the fiscal year that began on April 1, up from £34 billion the previous year and only £20 billion in 2008–’09. The issuance is part of a record borrowing program of £167 billion, up slightly from £166.4 billion in the previous year, and represents the highest proportion of index-linked debt — 22.7 percent — of any European country. “There is strong demand from U.K. pension funds in particular, and we want to meet that,” says Stheeman.

Her Majesty’s Treasury, along with those of many European countries, is in a relatively confident mood. But the past year’s events have transformed the concept of sovereign risk. Europe’s big borrowers will have to stay vigilant to avoid getting caught up in market turmoil.

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