(Bloomberg) -- The European Union’s bonds fell on Thursday as bets they would soon be added to key sovereign benchmarks received a blow, undermining the bloc’s efforts to broaden the appeal of its debt.

The yield on 10-year notes rose two basis points to 3.10% after MSCI Inc. announced late Wednesday it won’t add the EU debt to its range of government bond indexes because market participants are divided on the topic. 

The decision is a setback for the EU, which has been lobbying index providers to reclassify its bonds since the end of last year. The bloc is currently treated as a supranational issuer by index compilers, which it cites as a key reason why its borrowing costs are higher than those of European governments with similar ratings. 

MSCI’s decision “was not in line with our or the market’s expectations,” a Citigroup Inc. team led by Jussi Harju wrote in a note to clients. “The rejection could dissuade other index providers from even launching such consultations in the near term.”

Reclassifying the EU is a thorny concept, with the bloc politically divided on many traditional hallmarks of sovereignty, including joint debt issuance itself. Yet several investors have publicly backed including EU securities in government indexes. 

The MSCI consultation with market participants and those launched by other index providers show that the market sees the need to respond to the rapid emergence of the EU as a large-scale issuer of highly rated and highly liquid EU-Bonds, a European Commission spokesperson said in reply to emailed questions. The EU executive welcomes MSCI’s willingness to revisit this matter in the first half of 2025, the spokesperson added.

Speculation Dented

The outstanding volume of EU bonds is set to reach €1 trillion ($1.08 trillion) by the end of 2026, making it the fifth-largest issuer of debt denominated in the single currency. That means the case for inclusion in the leading bond indices will grow, the spokesperson said.

The rejection dents a wave of speculation that the bloc would swiftly be added to the more widely-followed government benchmarks from MSCI and others, which had helped the bonds to rally in recent months. An EU survey of investors last year found index inclusion was “the single-most important remaining step in order for EU bonds to trade and price similarly to European government bonds.” 

That said, EU bonds recovered ground after the open as investors digested the outlook. The securities are often compared to French debt due to their similar yields. Given the political uncertainty ahead of the French election, EU bonds can still outperform, according Hauke Siemssen, an analyst at Commerzbank AG.

“EU bonds are likely to not only surrender the modest premium at which they were trading, but also underperform given that MSCI has deferred a re-evaluation to the second quarter of next year.”

— Ven Ram, Bloomberg strategist

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MSCI was not the first index-provider to formally float reclassification. Intercontinental Exchange Inc. launched its own consultation back in April, with its decision due to be announced in August. Bloomberg LP, the parent company of Bloomberg News, also offers index products for various asset classes through Bloomberg Index Services Ltd.

“Medium term, the crucial question remains how other major index providers will react, as they have been tight-lipped about similar plans,” Commerzbank’s Siemssen said.

--With assistance from James Hirai.

(Adds comments from the European Commission in 6th and 7th paragraphs.)

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