Update – Credit investors dump US bonds and buy Europe
European credit markets are trading at a premium to the US for the first time in more than three years as investors have scooped up European corporate bonds and dumped US debt following a stark divergence in outlook for the two regions.
Investors now demand an extra 90bp of yield to hold euro investment-grade corporate bonds over ultrasafe government securities, according to ICE BofA corporate bond indices, compared to 97bp in the US. That has flipped a long-held dynamic in corporate credit markets. In early December, US credit spreads traded at 25bp below Europe.
Investors have scrambled to hedge exposures to weakening US credit markets as the economic outlook deteriorates, pushing US credit default swap index trading volumes to their highest levels since the outbreak of the Covid-19 pandemic in early 2020.
In Europe, meanwhile, Germany’s shock announcement that it would spend nearly €1trn on defence and infrastructure has ignited growth expectations on the continent and buoyed markets.
“The big topic of the moment is the outperformance of Europe versus the US," said Finbar Cooke, co-head of European credit trading at Barclays. "It’s very bifurcated. Political uncertainty around tariffs has had a real impact in the US, whereas Europe has had this once-in-a-generation boost in German spending. There’s a lot of tailwinds in Europe and a lot of headwinds in the US."
The twin shocks in recent weeks of the Trump administration’s yo-yoing tariff policies and Europe’s newfound fiscal largesse have roiled markets. The S&P 500 has fallen into correction territory after declining more than 10% from its February highs as economists have slashed growth forecasts in response to US tariff plans. The Stoxx Europe 600 index, by contrast, is up more than 7% this year.
Hedging the downside
Moves in corporate bond markets haven’t been as dramatic, but US investment-grade credit spreads have still widened nearly 20bp from their February lows to levels last seen in September. Many investors have turned to derivatives to protect themselves against further weakening. About US$312bn of US CDS indices tracking investment-grade and high-yield credit changed hands last week, according to DTCC data collated by ISDA.
That makes it the third busiest week on record, with only the period around the outbreak of the pandemic in 2020 seeing more activity. Traders say there has also been a steep rise in hedging using other instruments such as options on exchange-traded funds.
“Hedging activity is definitely picking up in credit derivative indices and ETFs,” said Andrew Sheets, global head of corporate credit research at Morgan Stanley. “We think hedging still makes sense here because there’s fundamental downside risk. You have a weaker growth outlook in the US and the potential that central bank support will be less willing to arrive. Both of those things are currently in play – and that absolutely matters to credit."
The outlook could hardly be more different in Europe, where economists are raising growth forecasts in response to Germany's plans to increase spending dramatically. Germany's 10-year yield has risen more than 40bp to 2.90% since Berlin's announcement – a move that has made European corporate bonds look more attractive for investors as they can earn a higher yield for owning these securities.
Investors have poured US$20.4bn into euro investment-grade credit funds this year, Bank of America said in a report on Friday, suggesting they are betting on brighter prospects in the region.
Can it last?
Not everyone is convinced Europe's winning streak will endure. The potential for tariffs to weigh on growth could yet dent the local economy. It's also unclear what impact a US economic slowdown would have on Europe.
"The question is: if US credit markets price in a recession or slowdown, can Europe be immune from that, and at what stage does it become a European risk-off move? We haven’t seen any signs of that, but it's a big talking point," said Cooke.
Heady valuations are another source of concern. Strategists at ING said the Bund component now accounts for more than 80% of the yield in euro investment-grade credit – a level comparable to 2005–07 preceding the global financial crisis when credit spreads were "remarkably tight".
"The credit spread remaining tight and becoming proportionately a small part of the yield equation could spark disinterest in credit," the strategists said.
Nonetheless, many strike a hopeful note given the upgrade to Europe's growth prospects. "The market is still underinvested in Europe and we think this outperformance will continue," said Cooke.
Sheets expects Europe will continue to outperform – and not just because of the changes to economic growth forecasts. He also noted that Morgan Stanley now expects the Federal Reserve to cut interest rates less than markets are anticipating this year, while projecting the European Central Bank and Bank of England will cut more – a dynamic that should support European corporate credit over the US.
"There are real fundamental differences that support the outperformance of European investment-grade credit," Sheets said.
European outperformance creates credit market quirks
The swift repricing of corporate credit markets on either side of the Atlantic has produced some unusual dislocations, particularly for emerging market issuers.
Several EM issuers now have tighter credit spreads on their euro-denominated bonds than their US dollar debt, bankers say, a dynamic that is virtually unheard of given the far greater depth of liquidity in the US.
"The euro market is bizarre at the moment," said a debt capital markets banker. "With euro yields selling off, and some bonds not especially liquid, in some cases spreads are tighter in the secondary than their dollar curve."
The banker noted that core emerging market issuers never price better in euros than US dollars. He predicted that the current secondary market levels would also prove to be a mirage for any EM issuer brave enough to attempt to shun the US dollar market in favour of Europe.
"Most EM euro bonds have outperformed the Bunds selloff and tightened. But can you execute close to those secondary levels? Probably not," the banker said. "So there's a danger [to euro financing] relative to the dollar market."
Sudip Roy