Investors pile in to European junk bonds as inflation cools

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European investors have been piling into the region’s risky corporate bonds to scoop up the chunky yields on offer, as they grow more confident in companies’ ability to refinance their debt.

A record $1.2bn has flowed in to European-listed exchange traded funds investing in the region’s high-yield bonds this year to Thursday, according to BlackRock data. That compares with flows in to European-listed ETFs investing in US high-yield bonds of just under $200mn.

This marks the first time that European ETF investors have favoured “junk” bonds in their home market over the US since 2019. Many believe that regional economies that are performing slightly better than feared means a more painful recession can be avoided, while falling inflation will allow central banks to cut interest rates, creating a supportive backdrop for junk issuers.

In contrast, the strength of the US economy and high levels of government spending relative to taxes could persuade the Federal Reserve to keep interest rates high for some time, say investors, which could hurt lower-quality companies.

“The European economy has been weak and diverging from the US over the past couple of quarters but, with the exception of German manufacturing, we think that’s starting to bottom and pick up,” said William Vaughan, associate portfolio manager at Brandywine Global. Bond yields have “come down enough from their peak that we see demand [from companies and households] for credit going forward”.

But Vaughan said that his worry for the US was that inflation could pick up again.

“You’ve got monetary policy on one side trying to slow the economy and you’ve got fiscal policy batting against it on the other, with the potential for tax cuts and employee retention credits totalling over $250bn before the election,” he said.

European investors have tended to opt for US junk bonds in recent years. However, the recent surge in demand for European credit has helped pull the spread — or gap — between risky bonds’ yields and those of equivalent German Bunds — the eurozone benchmark — down to the lowest level since 2022 at 3.4 percentage points. In 2022 the gap was as much as 6.5 percentage points.

The latest tightening of credit spreads comes as improved investor confidence helped push European stocks to a record high this week, boosted by blockbuster results from chipmaker Nvidia, which “transformed the mood of the whole global risk market”, according to Deutsche Bank strategist Jim Reid.

Investors say a rapid rally in government bonds in the final months of 2023 also helped push money into risky bonds this year, as falling borrowing costs helped alleviate fears around risky borrowers’ ability to refinance their debt. 

“The easing of financing conditions for euro area high-yield issuers has set in motion a positive feedback loop of declining borrowing costs, improving solvency and declining risk premia,” said Christian Kopf, head of fixed income at Union Investment.

The average yield on European high-yield bonds currently stands at 5.7 per cent, which seems “quite manageable” for most issuers, Kopf said. The new issuance many had expected for 2024 has not materialised as many companies have scaled back their spending and borrowing plans, he added.

Vasiliki Pachatouridi, head of iShares fixed income product strategy, Emea, at BlackRock, said that 2024 has the potential to be a “better year” for risk assets because investors are “looking for opportunities to put cash to work ahead of potential rate cuts”.

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