European Union bonds take a hit after MSCI index exclusion

(Corrects paragraph 2 to say that EU officials see index inclusion generally as a key step, not just MSCI)

By Yoruk Bahceli

(Reuters) -The European Union's borrowing costs rose on Thursday as investors tried to assess what MSCI's decision to leave the bloc out of its government bond indexes meant for jointly issued EU debt.

Global index compiler MSCI said on Wednesday that following an investor consultation it had decided not to include the EU's debt in its government bond indexes, throwing a curveball at a step EU officials have seen as key to their ambition for the bloc to be treated like a state by investors.

MSCI said it will revisit its decision next year.

With many investors having anticipated the EU's inclusion, its bonds had outperformed the bloc's individual governments in recent weeks.

On Thursday, the disappointment sent the EU's 10-year bond yield as much as 7 basis points higher to 3.13%. Its 30-year yield also rose as much as 7 bps to 3.51%, Tradeweb prices showed.

They later eased and yields were last up around 5 bps on the day, still underperforming the broader euro zone government bond market, where yields were 1-2 bps higher. Bond yields move inversely with prices.

The decision was "something of a surprise to the market," said Gareth Hill, portfolio manager at Royal London Asset Management.

But with the EU carrying top Triple A ratings, "this is not a credit call and at the margin, any cheapening arguably makes them more attractive now," Hill added.

Despite Thursday's selloff, the EU's longer-term bond yields remained lower than France's, which have shot higher this week after President Emmanuel Macron's unexpected decision to hold a snap election.

The EU, which expects to raise up to 712 billion euros ($772 billion) in common debt with the backing of member states by 2026 to finance a COVID recovery fund, has quickly become one of the biggest borrowers in global bond markets.

Index inclusion is the "single most important factor" to align the debt with that of governments, an EU investor survey last year said, boosting demand significantly.

WHAT NEXT?

Analysts said it wasn't clear what MSCI's decision meant for other index providers.

New York Stock Exchange parent Intercontinental Exchange has also launched a consultation on classifying the bloc's debt. The results will be announced in August.

More investors track Bloomberg and iBoxx's indexes, according to Citi analysts, so whether they follow suit will be key.

On the other hand Kaspar Hense, portfolio manager at BlueBay Asset Management, said what mattered more for the EU's debt was whether fiscal integration efforts continue.

A key challenge the EU would face regarding index inclusion was that its pandemic borrowing programme is temporary, investors have previously said.

A French government including Marine Le Pen's National Rally would make "discussions in the EU Council very difficult, in particular for defence spending where France is most important. That makes any continuation in funding via an EU vehicle less likely," Hense said.

Several EU countries have called for more joint borrowing to fund defence spending, and the EU executive has also broached the idea of a new fund. Any far-right opposition to further fiscal integration could dent those hopes.

"The outlook that (the EU) would be seen as a government has certainly decreased," Hense said.

(Reporting by Yoruk Bahceli; Editing by Amanda Cooper and Hugh Lawson)