Changing of the guard: Bonds react to European policy shifts
Tim Winstone, fixed income portfolio manager, considers the impact on credit markets of a seismic shift in tone on defence and fiscal spending in Germany and a more subtle policy shift at the European Central Bank.
8 minute read
Key takeaways:
- Proposals to allow Germany to spend more, particularly on defence and infrastructure, is a monumental shift in tone that has the potential to boost economic growth but could be inflationary.
- The European Central Bank, while not wishing to be drawn early into making predictions about the effect of fiscal policy, did signal a shift in tone, opening up the possibility of a pause in rate cuts at the next meeting.
- For credit investors, additional government spending has the potential to boost revenues and cash flows, but tight credit spreads mean there may be limits to how much corporate bonds can absorb any underlying rise in government bond yields.
In a week that was a watershed moment for Germany with a substantial fiscal policy and defence announcement, we also saw a more subtle shift from monetary policymakers as the European Central Bank (ECB) adopted a more “evolutionary” approach.
Germany’s fiscal expansion
Overshadowing the ECB decision was Germany’s announcement earlier in the week that it would seek a big fiscal expansion and rise in defence expenditure. The CDU/CSU and SPD parties propose pushing through constitutional changes while the old German government is still holding office and it is more likely it can secure a necessary two-thirds majority in the German parliament. The timeframe is tight as the newly-elected parliament has to commence by 25 March at the latest. Briefly there were three key elements:
- Defence spending exceeding 1% of gross domestic product (GDP) would be exempt from the current restrictions of the constitutional debt brake (essentially allowing the government to raise an unlimited amount of debt to finance military spending).
- The constitutional debt brake would be amended to align federal states with the federal government so that they would be allowed to incur new annual debt of 0.35% of gross domestic product (GDP).
- A special fund for infrastructure would be created allowing €500 billion of spending spread over 10 years.
Rearmament should be good for the country’s Mittelstand (the small and medium-sized enterprises) that are the backbone of the Germany economy. With a strong record in engineering, Germany should be well positioned to capitalise on the additional domestic spending.
More welcome is the €500 billion fund for infrastructure (spread over 10 years) and necessary to get Green party support. This has the potential to benefit revenues more broadly and across more cyclical parts of the economy (manufacturing and construction). The accompanying rise in equity markets in Europe that has occurred recently is also helpful in terms of sentiment and the ease with which companies can raise capital, which could potentially lead to more favourable debt/equity structures. From a credit risk perspective, therefore, more government spending and the attendant multiplier effect should be supportive for corporate revenues and cash flows.
Easier said than done
But could markets be getting a little carried away? Back in 2022, following the outbreak of the Russia/Ukraine conflict, Germany set up a special defence fund of €100 billion (the Sondervermögen) to boost Germany’s military. Yet this is still far from exhausted and not set to be fully used up until 2027. To spend a large amount on defence, Germany will need to overhaul its procurement and red tape. To that end, the CDU and SPD have agreed to enact a separate bill to speed up the planning and procurement process.
Every action has a reaction
There is a not unreasonable concern that throwing money at something might simply lead to higher inflation, as companies increase prices quicker than they build productive capacity. It is telling that the share prices of defence companies have soared recently as analysts predict higher earnings.
Moreover, higher federal and state borrowing is likely to lead to competition for capital – pushing up bond yields, all else being equal. Deutsche Bank noted that the last time Germany embarked on a massive stimulus programme (German reunification in the 1990s), the extra spending was estimated to have pushed up Holston-Laubach Williams (HLW) estimates of r* (the natural rate of interest) by around 100 basis points (bp).1 The proposed package is sizeable but smaller in relative scope but even so might be expected to push up German sovereign Bund yields by around half that amount.
Following the announcement of the German package, the 10-year Bund yield rose 30 bps to 2.79% on 5 March 2025, its biggest one day move of the last 30 years. In contrast, the yield on the ICE BofA Euro Corporate Index (Euro investment grade (IG) corporate bonds) rose only 20bp as credit spreads (the difference between the yield on a corporate bond and a government bond of similar maturity) absorbed some of the rise.
Figure 1: 10-year Bund yield jumps, although corporate credit absorbs the rise
Source: Bloomberg, Germany Generic 10-year Government Bond (Bund), ICE BofA Euro Corporate Index, yield to worst, 5 December 2024 to 5 December 2025. Yields may vary over time and are not guaranteed.
There are limits to how much of a cushion credit spreads can offer. At close of play on 5 March 2025, Euro Investment grade spreads were at 83bp, compared with a tight of 36bp over the last 20 years. Similarly, the spread on the ICE Euro High Yield Index was 274bp, which compares with a tight over the last 20 years of 178bp. Corporate fundamentals remain robust, which help justify current spread levels. There is room to tighten further but we need to be mindful that European investment grade spreads have only spent 13% of the last 20 years tighter than where they currently are and for high yield only 6%.2
On the other hand, duration on European corporate debt tends to be quite low given a prevalence in Europe for shorter corporate maturities (effective duration on Euro IG was 4.5 and on Euro HY was 2.7 at the end of February 2025.3 An effective duration figure of 2.7 means that a change in yields of 100bp is expected to change a bond’s price in the other direction by 2.7%. These relatively low durations should make any sensitivity to rises in yields more manageable, with the market adjusting fairly quickly.
We also need to recognise that many other factors affect corporate bond yields and spreads, from the individual conditions a borrowing company faces to investor appetite, so the fiscal background is just one dimension. A not unimportant factor is the monetary backdrop, which brings us to the latest ECB rate decision.
Known knowns and unknowns
Given all the excitement around defence spending of late, it feels fitting to quote Donald Rumsfeld, a former US defence secretary, and talk of known knowns. The 25 basis points (bp) interest rate cut by the European Central Bank (ECB) in March was not a surprise as it had been expected by markets. This brings the deposit rate down to 2.5%. The ECB sees inflation settling around its target rate of 2% over the next 2 years and averaging 2.3% in 2025. While recognising that monetary policy is becoming “meaningfully less restrictive”, the bank pointed out that the eurozone economy faces challenges, with economic growth projections marked down in response to lower exports, weak investment and uncertainty from trade policy.
It is easy to forget amid the flurry of excitement around the German fiscal package that economic growth in Germany and the eurozone has been moribund of late.
Figure 2: In need of a lift
Real gross domestic product (GDP) percentage change (quarter on quarter)
Source: Eurostat, Destatis, real gross domestic product, percentage change on previous quarter, Q1 2022 to Q4 2024, as at 25 February 2025.
ECB President Lagarde stressed that monetary policy would reflect three key things:
- Assessment of the inflation outlook in light of incoming economic and financial data.
- Dynamics of underlying inflation.
- Strength of monetary policy transmission.
A notable omission was deliberate mention of fiscal policy, although Lagarde in the press conference was quick to point out that assessing the impact of potential fiscal developments in Germany and Brussels (where the European Union was also discussing additional defence spending) was a “work in progress”. It was seen as too early for the ECB to be in a position to determine what precisely it means for inflation and growth, not least because the policy changes still need to clear political hurdles and be implemented. There was widespread agreement, however, that additional spending would be a boost to European economic growth.
What was clear was that the ECB was determined to stress optionality. Lagarde refused to pre-commit to a particular rate path, insisting the central bank would follow a data dependent and meeting-by-meeting approach. Lagarde recognised that they have moved from a more static assessment where rate direction was clear (downward) to a more evolutionary one that recognises that 150 bp of rate cuts have already taken place, opening the possibility of a pause. Lagarde referred to a recent meeting of the G20 in South Africa where she had used a metaphor of the waters around the Cape of Good Hope where warm water from the Indian Ocean (rate cuts) are still mixing with the cold water of the Atlantic Ocean (remaining effects of earlier policy tightening).
For bond investors, we were left with known unknowns, as each ECB meeting comes into play.
Taken together, the first week of March has mixed outcomes for credit investors. On the one hand, we welcome a more assertive Germany and the additional fiscal spending, which should help corporates, but the downside is a potentially less predictable path for rates. In common with the ECB, we will be paying close attention to the upcoming macroeconomic and financial data.
1Source: Deutsche Bank, Fixed Income Blog, 4 March 2025. Basis point (bp) equals 1/100 of a percentage point, 1bp = 0.01%.
2Source: Bloomberg, ICE BofA Euro Corporate Index, ICE BofA Euro High Yield Index, Govt OAS (option-adjusted spreads over governments), 5 March 2005 to 5 March 2025.
3Source: Bloomberg, ICE BofA Euro Corporate Index, ICE BofA Euro High Yield Index, effective duration, 28 February 2025.
The ICE BofA Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the Eurobond or Euro domestic markets.
The ICE BofA Euro High Yield Index tracks the performance of EUR denominated below investment grade corporate debt publicly issued in the Eurobond or Euro domestic markets.
Basis points: Basis point (bp) equals 1/100 of a percentage point, 1bp = 0.01%.
Corporate bond: A bond issued by a company. Bonds offer a return to investors in the form of periodic payments and the eventual return of the original money invested at issue on the maturity date.
Corporate fundamentals are the underlying factors that contribute to the price of an investment. For a company, this can include the level of debt (leverage) in the company, its ability to generate cash and its ability to service that debt.
Credit rating: A score given by a credit rating agency such as S&P Global Ratings, Moody’s and Fitch on the creditworthiness of a borrower. For example, S&P ranks investment grade bonds from the highest AAA down to BBB and high yields bonds from BB through B down to CCC in terms of declining quality and greater risk, i.e. CCC rated borrowers carry a greater risk of default.
Credit spread: The difference in yield between securities with similar maturity but different credit quality. Widening spreads generally indicate deteriorating creditworthiness of corporate borrowers, and narrowing indicate improving.
Debt brake: The failure of a debtor (such as a bond issuer) to pay interest or to return an original amount loaned when due.
Default: Legally binding for Germany’s federal government since 2016, and the country’s 16 states since 2020, the debt brake puts strict limits on borrowing. While there is an outright ban on debt for the states, the debt brake left some leeway for the federal government to spend during exceptional times and take on a small amount of borrowing in normal times.
Duration: A measure of the sensitivity of a bond’s price to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa. Bond prices rise when their yields fall and vice versa.
Fiscal policy: Describes government policy relating to setting tax rates and spending levels.
Fiscal impulse: The change in the government primary deficit (which excludes net interest payments) from one year to the next. A positive fiscal impulse is stimulatory for the economy, while a negative fiscal impulse is seen as contractionary.
Gross domestic product (GDP): The value of all finished goods and services produced by a country, within a specific time period (usually quarterly or annually). GDP is a broad measure of the size a country’s economy.
High yield bond: Also known as a sub-investment grade bond, or ‘junk’ bond. These bonds usually carry a higher risk of the issuer defaulting on their payments, so they are typically issued with a higher interest rate (coupon) to compensate for the additional risk.
Inflation: The rate at which prices of goods and services are rising in the economy. The Consumer Price Index is a measure of inflation that examines the price change of a basket of consumer goods and services over time.
Investment grade bond: A bond typically issued by governments or companies perceived to have a relatively low risk of defaulting on their payments, reflected in the higher rating given to them by credit ratings agencies.
Maturity: The maturity date of a bond is the date when the principal investment (and any final coupon) is paid to investors. Shorter-dated bonds generally mature within 5 years, medium-term bonds within 5 to 10 years, and longer-dated bonds after 10+ years.
Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. Monetary policy tools include setting interest rates and controlling the supply of money. Monetary stimulus refers to a central bank increasing the supply of money and lowering borrowing costs. Monetary tightening refers to central bank activity aimed at curbing inflation and slowing down growth in the economy by raising interest rates and reducing the supply of money.
R*(the natural rate of interest): Holston-Laubach-Williams models define r-star as the real short-term interest rate expected to prevail when an economy is at full strength and inflation is stable.
Yield: The level of income on a security over a set period, typically expressed as a percentage rate. For a bond, at its most simple, this is calculated as the coupon payment divided by the current bond price.
Yield to worst: The lowest yield a bond (index) can achieve provided the issuer(s) does not default; it takes into account special features such as call options (that give issuers the right to call back, or redeem, a bond at a specified date).
Volatility measures risk using the dispersion of returns for a given investment. The rate and extent at which the price of a portfolio, security or index moves up and down.
IMPORTANT INFORMATION
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High-yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings. products, such as mortgage- and asset-backed securities.
8 minute read
Key takeaways:
- Proposals to allow Germany to spend more, particularly on defence and infrastructure, is a monumental shift in tone that has the potential to boost economic growth but could be inflationary.
- The European Central Bank, while not wishing to be drawn early into making predictions about the effect of fiscal policy, did signal a shift in tone, opening up the possibility of a pause in rate cuts at the next meeting.
- For credit investors, additional government spending has the potential to boost revenues and cash flows, but tight credit spreads mean there may be limits to how much corporate bonds can absorb any underlying rise in government bond yields.