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Europe’s bond fund managers are scrambling to adjust their portfolios as Germany’s fiscal revolution triggered a dramatic move in government bond yields that spread as far as Japan.
Expectations for future government spending in the eurozone and beyond are shifting rapidly, sending longer-term bond prices tumbling and pushing up bond yields sharply.
Some managers are selling longer-dated holdings, while others are buying in order to take advantage of the lower prices and higher yields. Others are shifting toward corporate bonds, which offer higher yields than sovereign debt but have recently been less volatile.
“The events in Germany were the most significant on the fiscal front in 40 years, but the selloff has been the sharpest in the period too,” say TwentyFour AM portfolio manager Felipe Villarroel says.
Germany’s Fiscal Revolution and the Bond Impact
Yields on German government bonds have continued climbing after this week’s sharp spike, which follows the German government announcing a historic boost in spending and changes to the “debt brake”. The increase in bond yields comes despite the European Central Bank cutting interest rates for the fifth time in a row and lowering its growth forecasts for the eurozone.
Yields on 10-year German Bunds, the benchmark security for the eurozone and one that is considered the lowest risk, are at 2.79%, a rise of 43 basis points from a month ago.
Yields on French and Italian debt also rose, and the spread between Italy’s 10-year bonds over Germany’s is now hovering around 100 basis points, its lowest since September 2021. This gap or spread between Italian and German bonds is a key indicator because German bonds are considered the lowest risk in the eurozone.
Japan’s 10-year borrowing costs also hit a 16-year high on Thursday, at 1.52%, and yields on the US 10-year Treasury touched 4.32%. UK gilt yields on 10 and 30-year maturities also rose sharply.
How Fund Managers Are Reacting
“Longer duration assets have felt the most pain,” TwentyFour AM’s Felipe Villarroel says.
Duration is a key metric for bonds and measures the sensitivity of debt to interest rates; the longer the bond maturity, the more likely interest rates will impact on yields and prices.
In this case, longer maturity bonds, those from 10 years and beyond, have borne the brunt of the recent selloff, pushing up yields at the longer end of the yield curve.
The selloff creates a dilemma for managers: offload longer-dated or higher duration bonds in case of further weakness, or add to existing holdings.
“There’s a limit as to how high Bund yields can go before some market participants find yields attractive,” Villarroel says.
“In portfolios where the Bund allocations were larger and longer, we have trimmed 10 year and 30 year Bunds but not sold all of them.”
“We have shortened our duration in EUR assets by selling some Bunds. We have added small amounts of EUR credit [corporate bonds]. This is a significant event for rates but also for spreads [between government and corporate bonds]. There’s reason to believe that potential growth in Europe might be higher in the future which means spreads could be tighter, all else equal.”
Some Managers Are Adding Longer-Dated Bonds
Antonio Serpico, senior portfolio manager at Neuberger Berman thinks that this selloff presents a buying opportunity for owners of eurozone government debt.
“We have begun to rotate portfolios in this direction,” he says. “We have also begun to gradually add duration into portfolios given that, on the one hand, the announcement of the defense spending plan will have to be effectively implemented, and, on the other hand, we are living in a context laden with uncertainty for economic growth, which could suffer further slowdowns from the tariff wars”.
Howard Woodward, co-portfolio manager of T. Rowe Price’s Euro Corporate Bond strategy, sees signs of stability amid the selloff.
“Despite this significant movement in sovereign markets, European corporate bond spreads [the gap between investment grade and non-investment grade bonds] remained stable, indicating good resilience in the investment grade segment,” he says. In times of economic stress, the yield spread between less risky government debt and more risky corporate bonds widens, as well as the spread between investment grade and non-investment grade or junk bonds.
A Stronger European Economy and Bonds
Investors around the world demand more yield to buy debt following the announcement of Germany’s historic spending plan, even though this arguably reflects an improving outlook for Germany’s economy rather than concerns on the sustainability of its debt. Berlin has one of the lowest debt/GDP ratios in Europe at just 63%.
Goldman Sachs’ economics research team upgraded their German growth forecast materially, even assuming that spending will be scaled up gradually. “We raise our growth forecast by 0.2 percentage points to 0.2% in 2025, by 0.5 percentage points to 1.5% in 2026, and by 0.6 percentage points to 2% in 2027 relative to our recently upgraded baseline,” they say in their latest paper released on March 5.
Moreover, the fiscal news lowers the pressure for the ECB to reduce rates below neutral. Goldman Sachs no longer expects the governing council to cut at the July meeting and raises its forecast for the terminal rate to 2% in June. It had previously forecast 1.75% in July.
What’s Next for Bonds?
“Overall, we expect markets to continue to price in some increase in supply and potentially an increase in the inflation premium”, says Annalisa Piazza, fixed income research analyst at MFS Investment Management.
She argues that the market may see more of the same, with longer-dated bond yields rising more quickly than shorter dated.
“Steeper curves and some stabilization of yields at current levels are the most likely scenario for now,” she adds.
Yield curves reflect the different cost of debt for bonds across different maturities.
”Obviously, fiscal changes are only one of the factors that move markets nowadays. The balance of risks that will come from fiscal support and the potential tariffs coming from the US from April will help to calibrate market pricing.”
What Does This Mean for Yields and Growth?
Neuberger Berman’s Serpico says: “The European rate market now has to deal with expectations of an abundance of government debt and therefore has to move to a higher yield range than in the recent past. At the same time, though, we believe that in the medium-term European rates should reflect the fundamentals of the economy, which include weak growth and declining inflation.”
While volatility is extremely high, a lot has been priced in over the last couple of days, TwentyFour’s Felipe Villarroel says. “We would expect Bunds to find some support in the 2.9%-3% area. Bunds hedged back to dollars are now amongst the highest yielding developed government bond markets in the world.”
Additional reporting by James Gard
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.
