Spreads on European government bonds are at their lowest level since 2008. The periphery is benefiting from structural growth and European subsidies, while core countries such as France and Germany are weakening. Investors are wondering how much of that convergence remains once the carry trade turns.
“In a world where ‘carry is king’ risk premiums are declining across the board, and with them spreads on government bonds,” said Aymeric Guedy, fund manager at Carmignac. “Everyone is searching for carry.” The fact that on 5 February the ECB left rates unchanged at 2 percent and is expected to move little in the coming years gives that trade room to run. But investors are also raising questions about the convergence.
Gerard Moerman, head of liquid investments at Aegon Asset Management, sees strong economic growth in the peripheral countries of Spain and Portugal. But he also observed bonds being four, six, sometimes ten times oversubscribed. “From a valuation perspective, that does raise eyebrows, but the abundance of capital compresses spreads regardless of the underlying fundamentals.”
“The large volume in ETFs is also distorting the market through higher volatility, as they buy and sell indiscriminately,” Moerman said. “That creates opportunities for the active manager. We are underweight France and Belgium and prefer Spain because of the structural nature of its growth.”
iShares Core Euro Government Bond ETF—one of the largest in its category
Risk premium
Stronger economic growth in the peripheral countries is pushing yields down there, while German yields are rising due to the loosening of the Schuldenbremse. “That move is clearly visible in the swap market, where German bond yields historically traded well below swap rates, but have now converged with the 10-year and even moved above them in the 30-year segment,” said Rob Dekker, fixed income portfolio manager at Achmea Investment Management. As a result, yield levels have moved closer together. “Germany retains its safe-haven status, if only because of the liquidity premium,” said Moerman. Guedy also still views Germany as Europe’s safe haven but prefers the short end of the curve, which is less sensitive to duration and sovereign issuance.
Suparna Sampath, fixed income specialist at Vanguard, expects Spain in particular to narrow its spread with Bunds, from 37 to 30 basis points. At those levels, however, the question arises whether investors are still being adequately compensated for peripheral risk.
10-year spreads versus German Bunds (in basis points)
France, a long-time core country, will need to exercise budgetary discipline to regain favor with bond investors. “If France does not do this on its own, the market will impose discipline,” said Moerman. The market is now demanding a higher risk premium for France than for the peripheral countries. While other investors are underweight France, Sampath advised against that. “The price reflects the risk. We would not underweight France at this time.”
Pillars of support
The European recovery fund Next Generation EU (NGEU), established in 2021 to absorb the economic damage of the coronavirus pandemic through grants and loans for structural reforms, has substantially supported southern countries. Spain achieved cumulative growth of around 10 percent over the past three years, driven by NGEU investments worth approximately 10 percent of GDP. According to Dekker, however, the funds may still contribute to growth in 2027. Only in 2028 is NGEU-driven growth expected to taper off.
Fund manager Simon Bell of Legal & General Investment Management also does not expect diminishing tailwinds for the peripheral countries to lead to a cliff effect. “A transition to cohesion funds could partially offset the loss of NGEU grants.”
Guedy pointed to Italy, where the Superbonus 110 percent led to a boom in construction. This was a fiscal scheme introduced in 2020 that granted homeowners a tax deduction for sustainability renovations. “That does not automatically mean it led to structural economic growth,” he said. Italy’s debt-to-GDP ratio remains above 134 percent, down from the covid peak but still as high as before the coronavirus crisis.
The second pillar of support is the ECB’s Transmission Protection Instrument (TPI). The central bank launched this backstop in July 2022 to counter unwarranted spread widening, but it has never been activated. Like Draghi’s famous “whatever it takes” in 2012, the instrument does not need to be used to have an effect. “Without ever being deployed, the TPI has acted as a kind of backstop,” said Sampath.
Eurobonds
Converging yields could form an argument for eurobonds, but Moerman rejected that view. “The fundamentals do not justify it.” Investors prefer supranational bonds, which according to Sampath “offer credit quality comparable to sovereign bonds, but often with a more favorable risk profile.” The fact that the market favors these supranationals, where countries do not guarantee each other’s debts, over true eurobonds suggests, in her view, that investors are not counting on further fiscal integration.
Still, there are triggers that could disrupt convergence. Guedy sees risks in high technology valuations that could trigger a global risk-off move, immediately dragging peripheral bonds with it. Bell of L&G warned that concerns about France could increase once budget negotiations for 2027 begin, with presidential elections on the horizon.