European Fixed-Income Outlook: Fair Winds for 2024

Policy easing should help euro and UK sovereign bonds, while fundamental, technical and valuation factors are all supportive for euro credit markets.

From stubbornly high inflation through economic and geopolitical storms, 2023 brought a challenging backdrop for European bond investors. But as we approach 2024, we see attractive opportunities ahead. 

Falling Inflation Opens the Way for Rate Cuts

Euro-area inflation is already approaching target and, with more convergence likely, rates are set to fall in mid-2024 and through 2025. Considering the eurozone’s history of low economic growth, we expect rates could finish 2025 at 2.75%—45 basis points (bps) lower than markets are currently pricing in. The UK is following a similar rate-cutting path to the EU, but with lagging disinflation dictating a slower pace. Falling rates should be positive for euro and UK government bonds—and a tailwind for parts of the credit market. 

With the era of negative rates behind us, euro government 10-year AAA bonds offer positive yields of almost 3%, creating scope for yields to fall and prices to rise meaningfully. If economic growth should disappoint or a shock should cause equity and credit markets to fall, euro and UK sovereign bonds look set to perform well. 

European Yield Curves May Steepen

The main worries for euro and UK treasury markets are mounting fiscal deficits leading to excess government bond supply and higher inflation risk premiums. These global pressures point to likely steepening at the long end of the euro and UK curves, where such factors tend to have most impact, and where we think investors should be underweight. 

Currently both the UK and euro government yield curves are abnormally flat, and their long ends could steepen sharply as they return to more normal levels. The spread between short and very long–dated bond yields is currently around 20 bps in Germany and 43 bps in the UK, compared with 12-year averages of around 105 bps (Display).

We prefer UK and Euro government bonds with less than five years to maturity, which will likely be the most responsive to rate cuts and the least sensitive to the longer-term factors driving long-dated treasuries.

Several countries at the EU’s periphery have improved their credit ratings lately. While the recent Moody’s upgrade has boosted Italian government bond prices, we think Italy has more work to do to keep up with peers.

UK gilts look cheap relative to German Bunds, and we expect the yield gap between them will continue to narrow. The twin benefits of higher yields and some spread tightening would give UK gilts scope to perform well over the next six to 12 months.

Focus on Quality in European Credit Markets

For UK and euro credit, we think a focus on quality will be important in 2024, given likely tough economic conditions. Weaker issuers will face increasing refinancing risks, while quality issuers will likely be able to refinance maturing bonds at reasonable rates. 

We see the sweet spot for euro credit as the crossover zone between investment grade and high yield: BBB and BB-rated bonds. While more risk-averse investors will prefer BBB, our research shows that historically an allocation to BB has generated additional returns through the cycle in all but the worst default scenarios, with euro BBs outperforming BBBs over time by around 2% per year (Display).

Of course, euro BBB returns have been more stable. But on a risk-adjusted basis, BB still has an edge.

Fundamental, Technical and Valuation Factors Look Favorable

European credit fundamentals look encouraging. Corporate balance sheets started the tightening phase in good shape, and higher rates are feeding through only gradually to corporate costs. We expect euro and UK default rates will rise but stay relatively low at 3%–4% over 2024.

Technical factors are also supportive across European credit markets, particularly for euro high yield. The market has shrunk by almost 15% since 2021, owing to both recent maturities and a net €10 billion of upgraded credits migrating out of high yield to investment grade (Display).

The remaining euro high-yield market is skewed 64% to BB—which is currently the segment investors favor. Around 7% of the market will mature in 2024, but we think strong demand should readily absorb any new higher-quality supply.

In terms of current yields, valuations look supportive too. Euro BBB investment-grade bonds are yielding 5%—the same as the lowest-rated CCC bonds in 2017. And in euro high yield, a starting yield of 7.25% provides a substantial cushion against downside risks. Adjusting for interest-rate sensitivity, yields would need to increase by over 250 bps to wipe out that high income and produce negative returns. And to underperform sovereign bonds, spreads would need to widen from the current 483 bps by over 150 bps (Display). 

Evaluate Downside Scenarios

What could go wrong for a higher-quality euro credit allocation? In our view, a serious drawdown would need some combination of an imminent maturity wall, an economic shock leading to very high default rates, or big problems in an important sector. But currently, maturities are not a pressing problem, economies are stable and, in sector terms, the most troubled area is real estate, which is only 3%–4% of the high-yield market. As this whole sector has sold off, active management can have an important role to play in picking mispriced securities.

Of course, both the UK and the eurozone are facing tough problems, including persistent low growth. But from a bond investor’s perspective, high growth rates aren’t necessary. Bondholders’ returns won’t be impaired so long as governments and corporates have enough revenue to service their interest payments and can refinance their debts. On that basis, we think conditions in 2024 for both sovereign and BBB/BB credit bondholders will be fair.