The euro will be Europe's bonding agent

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In Bond markets, as in life, if you are big you can get your own way. Portfolio managers prefer to invest in big markets where it's easier to find a buyer for your unwanted securities, or a seller of the stock you want. The more potential investors a bond market has, the lower its yields can go, trimming borrowing costs for the country concerned.

Bond markets don't come bigger than the US market. Weighing in at $10,000bn (pounds 6,000bn), the US behemoth is the bellwether for global fixed-income securities. The European bond market, though, is set to test the US's benchmark status in the coming years, as the introduction of a single currency in 1999 creates a market big enough to challenge the dominance of Treasuries.

Once the 11 countries investors and analysts see as most likely to qualify for European Monetary Union have converted their debt into euros, there'll be a European bond market worth almost $7,000bn, big enough to compete against the dollar bond market for investors' cash.

Improved liquidity in European bonds, once they're all in the same currency, is likely to persuade global investors to increase the proportion of European debt in their portfolios - meaning cheaper money for the governments using the euro.

"There'll be a big impact on the overall benchmark position once the process is under way and the European bond market has critical mass," says Paul Abberley, head of fixed income at Lombard Odier Investment Management. "Europe has always suffered from its fragmentation."

Including government and corporate bonds, plus dollar-denominated debt sold by foreign borrowers, the US bond market is the world's biggest, most liquid market. Moreover, government securities - typically the safest in any bond market - account for 63 per cent of the market.

The ease of buying and selling dollar bonds, which include US government and corporate debt as well as dollar securities sold by foreign borrowers, has made them the investment of choice for the world's biggest portfolio managers. The bonds' status as representing the world's biggest economy also boosts their prestige. Less than half the size of the US market, though still ranking second in the global pecking order, comes the Japanese bond market with some $4,600bn of yen debt, more than 65 per cent of which is in the form of government obligations.

European countries joining EMU, and borrowers with debt in currencies being swapped for the euro, have three years to redenominate their debt into the new currency. Some countries, including France, have professed their determination to switch to the new currency immediately on 1 January 1999.

The German bond market, Europe's top representative, is currently third globally, weighing in at $3,100bn, though less than half of the market is in the form of government debt.

Add the bonds of countries likely to be founder members of the single European currency - France, Belgium, the Netherlands, Italy, Spain, Austria, Finland, Ireland, Luxembourg and Portugal, plus bonds denominated in European currency units - and the European bond market soars to almost $7,000bn, leapfrogging the Japanese market to become the second most important bond market.

With the euro expected to play a key role as one of the world's reserve currencies, central banks that add the new currency to their foreign exchange reserves are likely to increase their European bond investments. Moreover, investors who have previously shunned European bond markets as too small to bother with will be drawn into the market.

"It is highly likely, if we end up with the European single bond market, that central banks around the world and many private investors would rather hold the euro than all the currencies separately," says Jim O'Neill, chief currency economist at Goldman Sachs International.

A buoyant American economy means the US government has been able to scale back its borrowing, reducing the amount of bonds it needs to sell. Record tax revenue allowed the US Treasury to borrow a lower-than-expected $35bn at last week's quarterly note and bond auctions - the smallest amount in more than four years, and less than the $38bn economists had expected it to borrow.

These global bond market changes are set to push borrowing costs for European governments down, and allow European bonds to break the influence of the Treasury market. Shifts in the US often dominate the direction of European bonds, no matter what the differences between the US and European economies.

The correlation between changes in 10-year US and German yields from February to August - showing the degree to which Germany follows the US - was 0.711 per cent, compared with 0.005 per cent between US and Japanese yields. Zero per cent means there's no correlation, 1 per cent indicates perfect correlation.

"Once you have one substantial market, it may be driven more by domestic fundamentals, rather than by following Treasuries," Mr Abberley says. "The Japanese market has a low correlation. The euro market, when it begins, is likely to have a lower correlation than its individual components."

For the UK bond market, a minnow at just over $700bn, the creation of a single European bond marketplace has both positive and negative implications. The downside is that the UK government will be competing for funds against a much-enlarged European neighbour which is offering a wider variety of issuers in a single currency than the sterling sector can provide.

The upside, though, is that for a global investor looking for a play on Europe but nervous about the prospects for the euro, sterling bonds will look increasingly attractive as a safe investment haven.

q The figures in this article are taken from the September edition of Merrill Lynch's publication, 'Size and Structure of the World Bond'.

Copyright: IOS & Bloomberg