• In an environment marked by uncertainty, investors would be well served to ensure their portfolios are sufficiently diversified to guard against potential volatility.
• For investors with exposure to euro area government bonds, adding an allocation to euro investment-grade corporate bonds can help to balance portfolios and enhance income.
• Euro corporate bonds allow investors to capture term premium while diversifying across maturities, geographies and sectors.

A shifting macro backdrop has created uncertainty for investors

We have seen a dramatic shift in investor expectations. A year ago, many investors believed that a global recession was coming and high interest rates would hinder the real economy. By the end of 2023, with economies looking healthy, the potential of a soft-landing scenario became the new consensus as it seemed central banks would soon be able to cut interest rates without triggering a recession.

Fast forward to today and expectations have shifted again. Rather than a discussion of when and how quickly we might see rate cuts, investors now wonder whether some central banks will be able to cut rates at all in 2024. This is especially the case in the US, where above-target inflation has persisted. Consequently, the market now expects the US Federal Reserve (Fed) to cut rates perhaps only a couple times this year – or not at all.

Things are different in the euro area, where economic growth is not as strong as in the US. Given this backdrop, the European Central Bank (ECB) cut rates in June, diverging from the Fed and the Bank of England. Such a divergence is not unprecedented. The question of how far the ECB might deviate from other major central banks has introduced further uncertainty for investors to navigate.

Dealing with a higher-for-longer interest-rate environment

In a higher-for-longer interest-rate environment, traditional lower-risk investments like euro area government bonds may not offer attractive returns relative to the term risk involved. As central banks maintain elevated rates in their bid to control inflation, yield curves have remained inverted, meaning longer-term bonds have lower yields than shorter-term ones. This scenario has encouraged investors to seek alternatives that can offer better risk-adjusted returns.

Euro corporate bonds, particularly in the investment-grade (IG) category, emerge as a compelling complement to euro area bonds. Not only do euro IG corporate bonds provide a positive term premium, especially at longer maturities, but their consistent credit premium across the curve (as the chart below shows) makes them an attractive choice for investors looking to enhance their portfolio yield in a challenging interest-rate environment. Additionally, the diversification and quality of euro IG corporate bonds can help mitigate the volatility and risks associated with prolonged periods of uncertainty.

Where is Europe’s credit premium amid current uncertainty?

European yield curves: euro government bonds vs. investment-grade corporate bonds

Past performance is not a reliable indicator of future results.

Source: Bloomberg. Data as at 21 May 2024. Indices used: Euro IG corporates yield = EUR Europe Corporate IG BVAL Yield Curve Index; euro government bonds yield = EUR Benchmarks Curve Index.

A balanced maturity profile

When it comes to maturity breakdown, the longer duration profile of euro area bonds stands out. Unless an investor expects meaningful price appreciation driven by ECB easing, the absence of term premium means a higher exposure to the longer end of the curve might result in a sub-optimal risk-adjusted yield profile. Fortunately, much of the exposure sits in the intermediate range (3-7 years), where investors can capture the healthy credit premium on offer from euro IG corporate bonds versus euro area bonds.

By combining the two exposures, investors can reduce the longer-end bias of euro area government bonds by adding more intermediate-maturity bonds. In a scenario where interest rates remain elevated for a prolonged period, this could benefit investors as it reduces duration risk while increasing risk-adjusted yield. It’s also important to note that these two exposures are not dramatically different from a maturity perspective – they are complementary and blending them allows investors to maintain a more balanced maturity profile. The next chart shows how combining the two exposures allows investors to reduce euro area bonds’ longer duration tilt without significantly altering the overall profile.

Intermediate maturities reduce euro area bonds’ longer duration tilt

Maturity breakdown

Source: Bloomberg. Data as of 30 April 2024. Euro IG corporate bonds = Bloomberg Euro Aggregate Corporate Index; euro government bonds = Bloomberg Euro Aggregate Treasury Index. IG = investment grade.

Diversify your regional exposure

Unless an investor has a tactical view on Europe and wants a purely European exposure, there is a strong case for taking a more balanced regional approach in an environment marked by macroeconomic uncertainty. There is still the possibility of a regional downside surprise and, in such cases, yields can move against investors.

An allocation to euro IG corporates allows investors to diversify their regional exposure and thus mitigate some of the potential downside of holding solely euro area bonds. Euro IG corporates have a weighting of more than 40% to companies based outside the euro area, including 21% to firms in the US. There is also a nearly 16% weighting in the ‘rest of Europe’, which includes companies based in the Nordics, the Baltics and the UK. 

Importantly, while adding an allocation to euro IG corporate bonds adds regional diversification, it does not add exposure to other currencies. Euro IG corporate bonds are denominated in euros and thus do not add any excess currency risk, or additional volatility associated with currency. In this way, European investors can access bond issuance from global companies without needing to currency hedge their exposure.

Global issuer diversification as an alternative to euro area home bias

Country allocation

Source: Bloomberg. Country allocation based on country of risk. Data as at 30 April 2024. Euro IG corporate bonds = Bloomberg Euro Aggregate Corporate Index; euro government bonds = Bloomberg Euro Aggregate Treasury Index. IG = investment grade.

Embrace the sector evolution of global issuers

An allocation to euro IG bonds also allows investors to access a wide variety of corporate issuers. Indeed, given that euro IG corporate bonds’ profile is dynamic and sector weights shift over time, investors can capture future trends. If we look at the evolution of euro IG corporate bond sector allocations, for example, we see that consumer discretionary, healthcare and technology have seen the largest growth over the past decade, whereas communications, real estate and utilities have seen their weightings shrink the most.

Financial firms are far and away the heaviest weighting at 44%, and that proportion has not shifted materially over the years. Financials have consistently been the biggest issuers of IG bonds. Outside of financials, exposure to other sectors is more evenly spread. The next largest weightings are to consumer discretionary (9.4%), utilities (8.0%), industrials (7.7%), consumer staples (7.2%) and communications (6.6%). Euro area government bonds, by definition, offer no such access to corporate sector diversity.

Such corporate bond exposure can help investors to future-proof their portfolios based on the evolution of IG bond issuance moving forward, primarily in Europe but also beyond.

IG credit: an income optimiser in euro portfolios

Looking at data going back to 1998¹, we can see that IG credit can help optimise the risk-adjusted income profile of European investors’ bond portfolios. Importantly, the data hold significance as they span a variety of major events, including the introduction of the euro, the global financial crisis (GFC), Covid-19 and current stagflation fears.

During this 25-year period, there have been instances when euro area government bond yields were higher than those of IG corporates, especially after the GFC. However, throughout the whole period, risk-adjusted yields² have been higher in IG corporates, both from a volatility and duration perspective.

The historical benefit of adding euro IG corporates to a euro area government bond exposure has been clear: a decrease in overall volatility, due to a less-than-perfect correlation (0.76) between the two exposures, coupled with euro IG corporates’ higher diversification has led to a higher risk-adjusted portfolio yield³.

As investors continue positioning themselves for a higher-for-longer interest rate environment, such benefits should not be ignored.

¹ Vanguard, Bloomberg. Data are weekly for the period 3 July 1998 to 29 March 2024. This is the longest period available for the two relevant indices. Indices used: euro investment grade corporate bonds = Bloomberg Euro-Aggregate Corporate Index; euro government bonds = Bloomberg Euro Aggregate Treasury Index. Yield calculated as average yield to worst divided by modified duration.

² "Risk-adjusted yield” is a metric that assesses the yield of an investment while accounting for the risks associated with achieving that yield. It provides a way to compare the efficiency of different investments by evaluating how much risk is incurred to generate a specific level of yield.

³ Source: Vanguard, Bloomberg. Data are weekly for the period 3 July 1998 to 29 March 2024. Indices used: euro investment grade corporate bonds = Bloomberg Euro-Aggregate Corporate Index; euro government bonds = Bloomberg Euro Aggregate Treasury Index. Yield calculated as average yield to worst divided by modified duration.