European Credit Outlook 2025
Whether weathering volatility through higher quality, taking advantage of short duration strategies or benefiting from carry in high yield and loans, investors will need to remain flexible to take advantage of developments in credit markets.
Performance in 2024
European credit markets have shown a positive return and outperformed government bonds this year. European investment grade and high yield spreads tightened by -29 bps and -54 bps respectively, by the end of November. On a total return basis, the ICE BofA Euro Corporate Index has risen 5.1% year-to-date, while the ICE BofA Euro High Yield Index has recorded a 7.9% rise as of the end of November.
European Investment Grade and High Yield Returns Year-to-Date
Source: Eikon as at 30 November 2024
The natural question at this point is how much return potential European credit offers in 2025, and what would be the right strategy to pursue?
Valuations
Looking at valuations, we see a mixed picture. On one hand, yield levels in European credit remain elevated across both investment grade (IG) and high yield (HY) enhancing the asset class’s appeal by providing a cushion against market volatility and a positive real income. On the other hand, European credit spreads on an index level (measured over government bonds) have tightened below their historical averages and no longer look cheap. However, from a global perspective these spreads still remain wider than their US counterparts, which are trading at historical tights. Moreover, there is market dispersion which presents opportunities in certain areas across the rating spectrum. Within the IG space, single A-rated bonds look particularly attractive. As illustrated in the chart below, which depicts the spread compression between BBBs and As, it’s historically cheap to move up in quality.
Spread pick up of BBB over A
Source: Bloomberg as at 30 November 2024.
Within high yield, CCC-rated bonds are also currently attractive from a value perspective, as they are trading at the 67th percentile over the past decade, which signals a cheapness compared to history. Even though the CCC-bucket is a small portion of the European HY market and includes names that undergo a restructuring, it provides interesting idiosyncratic opportunities.
Examining current spread levels more closely raises the question whether credit spreads have truly tightened meaningfully or if there has been an increase in sovereign risk. Taking a closer look at spreads over swaps - rather than Bunds - the chart below provides a different angle. Valuations in comparison to swaps are far more appealing than when compared to Bunds. In the current environment, it may be advantageous to look at spread to swaps for credit valuations, particularly in Europe, as government fiscal dynamics may be distorting credit valuations, making them appear richer relative to government debt in this cycle. The difference in valuations is particularly pronounced for single A-rated and BB-rated bonds.
European credit valuations - last 10yr history percentiles
Source: Bloomberg as at 31 October 2024. A percentile above 50 indicates that valuations are historically cheap, and a percentile below 50 indicates valuations are historically rich.
Expanding on these government fiscal dynamics, fiscal policy continues to be a concern in light of potential tax cuts and rising budget deficits particularly in the US, but also in Europe. While deficits are problematic, corporate bonds are well-positioned to navigate these challenges due to their ability to restructure debt, potentially rendering them a safer option than government bonds in certain markets. This is because these rising deficits will require governments to issue more debt at higher yields to finance these shortfalls, effectively increasing leverage in government fiscal structures.
Macroeconomic environment and corporate fundamentals
From a macroeconomic perspective Europe is struggling to gain momentum, with recent indicators revealing that the weakness in manufacturing has now spread to the services sector. Additionally, concerns regarding job security, exacerbated by announcements of further redundancies in the automotive sector have significantly weakened consumer confidence in Germany.
The outlook is further clouded by the risk of trade tariffs on exports to the US, alongside ongoing political uncertainty in France and the prospect of elections in Germany in early 2025 following the collapse of the coalition government.
While the Eurozone Consumer Price Index (CPI) is currently above the 2% target, inflation is likely to moderate, as service sector inflation should decline further driven by a weaker labour market.
We continue to believe growth in Europe will remain subdued and that further significant monetary easing from the central bank is required to support any sustainable recovery in economic activity. The good news is that the declining inflation is providing the European Central Bank (ECB) with the opportunity to ease monetary policy to support the economy. This shift could provide some much-needed support to the Eurozone to achieve a soft-landing.
In contrast, the re-election of Donald Trump is expected to have a reflationary effect on the US economy. His policies—centred on expansionary fiscal measures, tariffs, and reduced immigration—are likely to drive higher growth rates and inflation. However, the implications for US monetary policy remain uncertain. If both growth and inflation accelerate under his leadership, US interest rates may remain elevated to counter inflationary pressures.
Despite the challenging macroeconomic outlook for Europe, it provides a positive backdrop for European credit. The low growth in the European economy has encouraged companies to focus on improving their financial health by cleaning up balance sheets, cutting costs, and curbing spending. This approach has resulted in a reduction in leverage levels, particularly in HY. From a creditor’s perspective, these measures should yield positive results, and while Europe’s low-growth environment poses challenges, the corporate fundamentals remain solid, offering opportunities for credit investors.
Technicals
Investors have significantly increased their credit purchases this year, allocating EUR35 billion year-to-date into Euro IG bonds and EUR11 billion into Euro HY bonds. From a technical standpoint, we expect to see a continuation of this trend and positive demand for credit, supported by positive real yields. Looking ahead, as interest rates gradually decline, we expect a shift in appeal from IG to HY credit, where the higher yields are likely to attract further inflows from yield-seeking investors.
Preliminary conclusion
So, while credit spreads in excess of government bonds seem tight on an index level, there is far more under the bonnet. Attractive all-in yields, robust demand, and a macroeconomic backdrop leaning towards a soft landing – potentially facilitated by supportive monetary policy in Europe – coupled with pockets of value we see within the market, foster optimism about the future. However, considering the strong returns in 2024 and the current opportunity set, it is sensible to position our portfolios more defensively.
Moving forward, a combination of positive carry and idiosyncratic opportunities is expected to underpin total returns from the European credit market. The rise in government budget deficits is also a good reason for investors to reassess the role of government bonds within their portfolio and the implications on credit valuations, as sovereign risk increases.
In this environment, active management becomes even more essential. The ability to adjust portfolio exposure in response to emerging themes and changing market conditions will be paramount for achieving superior investment outcomes. Additionally, active management plays a vital role in navigating market volatility, mitigating downside risk, and capitalising on alpha opportunities as they arise. History has taught us that crises can occur unexpectedly, and it remains impossible to predict where the next one will emerge.
Volatility creates opportunities throughout the cycle
Source: Schroders, ICE, December 2024.
Opportunities currently exist and will continue to emerge in the future. One sector to watch is the automotive industry where we may see more pronounced stress and potential alpha opportunities in the future. Uncertainties stemming from potential tariffs under Trump’s administration, coupled with a weakening European manufacturing sector, have created challenges for the European auto industry. This scenario presents the auto sector as a compelling case for idiosyncratic opportunities, particularly if spreads widen further.
Another area where we see value in is Eastern European banks. Although the financial trade has largely played out, we maintain a constructive outlook on Eastern European banks, which are perceived to offer on an idiosyncratic basis a more attractive risk/reward profile than their Western European counterparts, supported by robust corporate fundamentals.
Now, if we zoom out on a strategy level, we have identified a couple of key areas of opportunity within the credit market.
Short and Sweet
The current market environment presents a compelling case for investing in short-duration credit. The flat, and in some markets even inverted, yield curve makes the front end attractive. This is because investors are being offered a high level of carry, at a lower level of volatility, from both an interest rate and spread duration perspective. This is particularly relevant for investors looking to limit risk exposure, focussing on a higher Sharpe ratio as the short end provides a safer place to ‘hide’ from volatility, while potentially capturing incremental returns. Additionally, as the rate cutting cycle continues, the short duration segment can benefit from a normalisation of the shape of the yield curve.
European High Yield and Leveraged Loans
Another interesting opportunity for 2025 lies in the European HY and Loans market.
Despite compressed spreads on index level for European HY, the total return outlook remains positive, driven by elevated yields and an average cash price below par. Moreover, the current yield levels in both markets offer strong carry that cushions against market volatility, even in an extremely negative economic scenario.
Finally, the demand is expected to remain robust as yield-focused investors shift incrementally from IG to HY and Loans in response to central bank rate cuts. Meanwhile, default risks are expected to remain subdued, supported by a manageable maturity wall, as issuers have proactively addressed their refinancing needs for 2025 and 2026 and the prospect of an economic soft landing. However, we need to be mindful that valuations in European high yield apart from the CCC segment look rich and that thorough research is needed to identify idiosyncratic opportunities.
Conclusion - Preparing for 2025 and Beyond
As we look to the future, markets present both opportunities and challenges. Valuations, sector-specific dynamics, and technical factors all point to the importance of a nuanced approach to the credit markets. Whether navigating volatility through going higher up in quality, leveraging short-duration strategies, or benefitting from the carry in high yield and loans, investors must remain agile and informed to capitalise on the evolving landscape.
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