Remember the EU Sovereign debt crisis? That continent wide debt conflagration that began sometime towards the end of 2009, raged across Southern Europe until  2012/13,  then somehow, gently slipped out of everyone’s minds? The same one that almost saw Greece leave the Eurozone, challenging the integrity of the Euro itself?

From the chart, you can see the increase in Debt/GDP levels from 2011 onwards, when the crisis really started to take hold. This was largely due to the sharp contractions in GDP across Portugal, Spain, Italy, and Greece as soaring debt funding costs severely hampered their economic situations.

From then on, Debt/GDP remained pretty stable, even decreasing in Portugal and Spain, as the years rolled by, until Pandemic 2020, which delivered the double whammy of increased debt levels and decreased economic growth. While final numbers are not yet available, for the year 2020, Greece is estimated to have Debt/GDP hit 205%, Portugal 134%, Spain 114% (actual figure as of 3Q 2020), and Italy at 158.5% for 2020.

Given these eye-wateringly high Debt/GDP levels, one cannot help but wonder how it is that these countries, only slightly more than half a decade out of a crippling debt crisis, can raise debt in record amounts, and at record low yields?

We know that their economies are in dire straits because of Covid, with extended lockdowns over two (three in some places) waves of Covid and the abrupt shutting down of the global tourism industry hitting all four countries hard.

Furthermore, their debt balances have not improved. On the contrary, Covid has caused these countries to borrow even more as they desperately try to prop up workers and businesses left (very abruptly) without sources of income for a prolonged period of time.

Not good on the growth front, and not good on the debt front; bond market participants obviously know this, why then are they falling over themselves to lend these countries money?

The favorite, go-to answer is of course the ECB buying sovereign debt as part of its QE program. ECB demand pushes prices up, lowering yields and hence borrowing costs for heavily indebted Eurozone countries. More importantly, the ECB’s continued willingness to purchase sovereign debt has imbued the bond market with the belief that the central bank will always step in when bond yields of heavily indebted nations get too high. As long as this belief holds, funding markets seem to be willing to remain open to Portugal, Spain, Italy, and Greece. Belief is a powerful thing.

Another arguably more important, but much less well known reason, is that EU debt is also used as repo collateral. While it may seem counterintuitive that the bonds of heavily indebted governments are used as collateral for loans, consider that we are living in an environment where central banks are actively buying large volumes of government debt, leaving less and less for participants in the repo market. 

This lack of supply of government debt for use as collateral has led to higher prices for the most liquid sovereign bonds (those in the US, Europe, and Japan), as repo participants bid higher to get their hands on what is left.

As such, and quite ironically, scarcity of collateral due to ECB buying has kept demand for the debt of Eurozone countries high – whether they intended it to, or not!