Investment Outlook
Amid market volatility, evolving geopolitics, and see-sawing currency valuations, fixed income investors can consider the following exposures:
- European credit, following Germany's reshaping of Europe's fiscal outlook.
- Convertible bonds, which have performed well despite equity and bond volatility.
- Emerging market debt, driven by a weaker US dollar.
Retreating to the Short End of the Euro Credit Curve
- Germany is reshaping the European fiscal outlook by committing to greater defence expenditure. Steeper curves look likely. Focus on the short end of the credit curve to both reduce exposure to issuance risks and lower sensitivity to yield moves. A stronger growth dynamic combined with lower short rates should be constructive for high-yield issuers.
The recent changes to German fiscal laws have produced an adverse reaction in the European bond market, pushing the 10-year Bund yield up by around 40 basis points (bps) from its end-of-February levels. The move was driven by a combination of higher real yields and breakevens, hinting that there is optimism that this can improve the long-term economic growth trajectory. There are other factors supporting growth expectations, including the more stable backdrop to the Chinese economy and some small steps towards a ceasefire in Ukraine.
Despite being predominantly a German fiscal story, rising German yields have dragged other European bond yields higher. With Germany retreating from tight fiscal management, other nations may also choose to run slightly looser policy.
The key question for investors is: To what degree can yields at the longer end of the curve continue to drift higher? Figure 1 shows the German 2-10 Year bond yield spread plotted against the 1 Year rate, segmented by calendar years. It shows that the curve remains flat relative to pre-GFC levels.
Figure 1: German 2-10Y Spread Still Flat versus Pre-GFC Levels
Flat curves make sense in the context of the European Central Bank (ECB) buying bonds, and in a market starved of issuance. But, the ECB has not been buying meaningful amounts of government bonds since mid-2023. With issuance expectations rising, a more limited premium should be attached to German debt. In short, yields could continue to rise to levels of steepness consistent with 2008. This has already happened for the France, US, and UK markets, where fiscal policy has been less-aggressively managed.
Short End Focus
Uncertainties over issuance, the flatness of the German curve, and inflation concerns generate risks for bond investors. These can be reduced by focusing on the front end of the curve for three reasons:
- The ECB is expected to deliver two further rate cuts in 2025. Only a significant and sudden surge in growth and inflation would blow it off course. The climate, therefore, supports short-dated bonds.
- Lower duration means reduced price sensitivity to changes in market yields, which will be defensively supportive if rates do rise.
- The front end of the curve is usually less sensitive to supply than the back end (longer-term bonds).
A key concern for investors is that shifting to the front end of the government curve means accepting a lower yield, given the curve is upward sloping. This can be mitigated by shifting into Investment Grade (IG) credit.1 One benefit of this is a likelihood of lower issuance pressures. As Figure 2 illustrates, January and February were busy months for EUR IG issuance, but April, June, and July are typically months with limited issuance. The recent exception was 2020, when outright yields were exceptionally low, prompting corporates to issue.
For those concerned over the increase in credit risk, there is little evidence of any deterioration in balance sheets of IG issuers. The upgrades/downgrades ratio for European IG was 3.92 in Q1 for S&P, 1.17 for Moody’s, and 2.92 for Fitch Ratings.2 Fiscal stimulus should also support growth and, through that channel, corporate earnings.
Is There Still a Case for Euro High Yield?
Considering the potential for better European growth, is it worth continuing to hold European High Yield? The key threat to the strategy comes from a broad risk-off move potentially triggered by tariff wars. Nonetheless, a short duration/high yield combination does provide some advantages:
- Their risk profiles differ, but the Bloomberg Liquidity Screened Euro High Yield Index has a duration of 2.53 years, which is only slightly shorter than the Bloomberg Euro Government 1-5 Years Index (2.75), yet its yield-to-worst of 5.61% is over double the 2.33% of the government index. The recent high-yield sell-off has pushed the option-adjusted spread back over 320 bps, roughly equal to the wides of the year.3
- The breakeven on the Bloomberg Liquidity Screened Euro High Yield Index is over 200 bps. A substantial yield increase or spread widening would be necessary to wipe out the annual index yield.
Exposure to the front end of the euro credit curve provides a similar yield to an all-curve euro government exposure, but with a lower duration and with potentially less exposure to issuance risks. An improved growth outlook for Europe could imply spreads can remain relatively stable. This has been borne out by price action so far in 2025, with credit spreads on the Bloomberg Euro Corporate Index 4 bps tighter since the end of 2024 versus 13 bps wider on the Bloomberg US Corporate Index.
Implementation Ideas:
Convertibles Riding out the Storm
- Convertible bonds have performed well during the early part of 2025 despite equity and bond volatility. Characteristics such as short duration and slightly lower price sensitivity to equity moves can continue to prove beneficial.
We focused on convertible bonds in Q1 on the basis that the strong backdrop for risk assets that we had seen in 2024 would persist into 2025. This was briefly the case but soon many risk assets started to struggle — US equities gave up their new-year gains. Conversely, European risk assets, equities in particular, have flourished as Germany released its fiscal brake.
Despite these rather unexpected market developments, convertible bonds have held-up well. The FTSE Qualified Global Convertibles Index returned just under 3% in Q1.4 This indicates their resilience given US exposure is high (62%) and the US equity market has suffered more than most. Several factors underpin this resilience:
- The duration on the FTSE Qualified Global Convertibles Index is a relatively short 2.8 years. This renders convertible bond prices relatively insensitive to yield changes. Treasury yields have actually fallen, providing support, while European and Japanese5 yields have risen sharply, underlining the advantages of global diversification.
- The exposure has a crossover rating. Credit spreads widened in March, particularly for US bonds and more so for lower-rated bonds. But since close to 64% of the convertible index is investment-grade rated,6 this would have had a limited impact on performance.
- Convertibles have shown a lower sensitivity to changes in the S&P 500 over the past two years. Figure 1 compares the weekly changes in the FTSE Qualified Global Convertibles Index between 7 April 2023 and 31 March 2025 with the weekly changes for the two years before that (2 April 2021 to 31 March 2023). The R-squared numbers are similar but the more recent two-year period has a lower beta coefficient, suggesting convertible returns are showing lower sensitivity to the S&P 500 now.
- Close to 25% of the FTSE Qualified Global Convertibles Index is invested in Technology bonds. Technology has been a source of equity underperformance and may struggle to rebound, given enduringly high large-cap tech stock valuations. However, the tech component of the convertibles universe has a far lower market capitalisation and does not trade at Magnificent 7-type multiples.
Figure 1: Converts Have Become Less Sensitive to the S&P 500
Weekly changes in the FTSE Qualified Global Convertibles Index against the S&P 500 since 2 April 2021.
Bolster Defenses
During the recent equity declines, the FTSE Qualified Global Convertibles Index delta fell to 45, the low end of its range since September 2024.7 This lower price-sensitivity of convertible bonds to the underlying equity exposure provides a defensive profile against a further decline in equity markets.
Bond yields having been high since late 2022 so convertible issuers are being forced to pay a meaningful coupon again. This has pushed the running yield on the FTSE Qualified Global Convertibles Index above 1.3% to its highest since October 2015.8 This is not a princely yield compared to some other corners of the fixed income market, but converts’ inherent yield sacrifice is the price for accessing the underlying equity optionality. And this figure is more than double the yield seen at the lows in early 2021, and it ensures some return regardless of whether the bond converts.
Convertible bonds continue to look attractive given their defensive profile of low-duration risk, crossover ratings, and a drop in the sensitivity of the bonds to both the underlying equity index and, more broadly, to US equities. The changing fixed income landscape has also pushed average coupons higher, which ensures some return regardless of whether the equity element of the convertible bonds are realised.
Implementation Ideas:
Emerging Market Debt Watching the US
- Strong Q1 returns from Emerging Market (EM) Local Currency debt were driven by a weaker US dollar. EM central banks have room to cut rates further but US economic data and tariff news will be key. The inclusion of India in EM indices is well under way, which raised inflows. This could be a positive demand factor for Saudi Arabian bonds if they are included in local currency indices.
The first quarter was proof that even the best laid plans often go awry: European equities outperformed their US counterparts, while Treasurys rallied and European government bond yields rose. Local currency emerging market debt was a surprise performer — the Bloomberg EM Local Currency Liquid Government index returned 3.75% over the quarter, better than US Treasurys, or even US high yield.9
Much of this was down to the dollar. US dollar weakness is a key tailwind for EM debt performance. It drove positive currency returns, with all but three of the 19 countries in the Bloomberg EM Local Currency Liquid Government Index posting positive returns from currency. The flows-weighted US dollar index (DXY) fell 4% during the quarter. The question for EM investors is whether this downward trend can continue. Talk that the US administration is seeking a weaker currency and the pattern followed by the DXY in Trump’s first administration, — the dollar fell in the first three quarters of 2017 — both hint that further weakness may come.
There are risks to EM FX from the imposition of tariffs. Asia, in particular, could suffer given the substantial volumes of trade it does with the US. There should already be a risk premium for this embedded in FX markets.
US economic data will be the key market focus because it will impact dollar valuations, and because EM central banks will be attempting to second guess the Federal Reserve’s (Fed) policy path. EM central banks remain in easing mode. Nine of the 19 central banks covered by the Bloomberg EM Local Currency Liquid Government Index have cut rates in 2025. Only Banco Central do Brasil has tightened. Expectations that the Fed will not deliver the anticipated 85 bps of cuts for 2025, which the market has already factored in, may generate reluctance to ease policy in case it results in currency weakness. But declining inflation means that emerging central banks are once again in the comfortable position of having high real interest rates. Figure 1 shows the average central bank rate less CPI for the nineteen countries that compose the Bloomberg EM Local Currency Liquid Government index. A real central bank rate of 3.25% is well above its 20-year average (1.20%) and is comfortably tighter than real policy rates in the US (1.70%), Germany (0.35%), or the UK (1.70%). This suggests EM central banks still have plenty of room to ease policy.
New EM Index Candidates
The inclusion of India in the Bloomberg EM Local Currency Liquid Government index is well underway. India formed 3% of the index at the end of March. This has acted as a modest drag on performance: Indian bonds returned 3.34% over Q1 against the whole index return of 3.75%. India should improve returns over the long term as their yield to worst is 6.78% against the index average of 6.3%.10
According to the Institute of International Finance (IIF) data, inflows into Indian bonds eased in Q1 2025, following a bounce around the time of its admission into the J.P. Morgan Local Currency Indices in June 2024 (Figure 2).
Flows have been volatile, although data suggests increased inflows into both Indian and Chinese bond markets around 6-8 months ahead of inclusion and then a bounce in the months after. Big declines in inflows ahead of the inclusion dates may be explained by idiosyncratic events. China government bond demand fell during the COVID-19 pandemic, and India Fully Accessible Route (FAR) bonds declined around the start of the Indian election process.
Saudi Arabia remains a potential candidate for inclusion in J.P. Morgan’s EM local currency indices. The nation’s bonds would constitute roughly 6% of the Emerging Markets Global Diversified Index. This is less weight than China or India, but foreign holdings of Saudi Arabian bonds are thought to be very low. The IIF does not record bond inflows for Saudi Arabia — in part due to its relatively recent development. But it is growing — the local portion of the J.P. Morgan Saudi Arabia Aggregate Index increased from 21.8% in October 2024 to 22.3% at the end of March 2025.
The Saudi economy certainly provides a positive backdrop for inclusion with firm growth and low inflation.11 Low oil prices have hindered revenues but prudent government spending has not gone unnoticed by ratings agencies. S&P upgraded the kingdom to A+ in March.