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European Bonds: A Hidden Gem for High Yields and Capital Gains

For many bond investors, the current rise in interest rates has provided plenty of opportunities. From traditional treasuries to junk debt, a variety of IOUs are now paying yields not seen since before the Great Recession. There really is a lot of choice out there to get good yield.

But only a few bond types currently offer the chance for capital appreciation as well. That includes European and Euro bonds.

Thanks to several tailwinds, bonds issued by the E.U. and other governments on the continent offer strong yields and a chance at gains. In that, European bonds may give U.S. Treasuries a run for their money this year and next. It’s no wonder why several big institutional investors have started buying them in spades. Retail investors may want to follow suit. *

European & E.U. Bonds Bounce Back

The size of the world’s bond market is staggering at over $133 trillion. That size dwarfs the world’s equity market by a lot. The United States is the largest individual market within that bond universe. So, naturally, many U.S. investors spend much of their effort crafting their fixed income portfolios here.

But ignoring Europe may be doing their portfolio a disservice. Bonds issued by the European governments, including the European Union, have bounced back in a big way.

Like the U.S., various governments in Europe and Eurozone cut rates to bare-bones levels during the Great Recession. In fact, at one point, bonds in Europe were yielding in the negative. Thanks to a poor economic recovery and worries about growth, investors were willing to pay money for safety. The pandemic exacerbated this situation.

However, like the U.S., the post-COVID snapback in Europe has been strong. Inflation surged to a peak of 10.6%, above the United States’ 9.1% peak inflation rate. Naturally, Europe raised rates to combat this problem just like the Federal Reserve.

However, that’s where the similarities end.

Lower Inflation & Declining Yields

Europe’s pace of rate hikes hasn’t been as severe as the United States. The Federal Reserve has benchmark interest rates at 5.25%, while the European Central Bank has rates at 4.5%. The lower rates seem to be working as well. Europe could cut sooner and more sharply than the U.S. That’s because Europe’s economy is already seeing signs of a soft landing.

For one thing, rate hikes in Europe have worked well to calm inflation. After hitting 10%+ peak, inflation in the Eurozone is now at 2.6%. Analysts and policymakers in the region now predict it should average 2.0% for 2024, down from the 2.7% average reached last year and at the European Central Bank’s target. At the same time, economic activity has slowed enough to continue the streak.

In the U.S., inflation has stayed strong, currently at 3.4% for April. That’s still running very high compared to the Fed’s target. To make matters worse, the metric has spiked higher over the last few readings, while economic data appears to be growing.

This has the U.S. and Europe moving in opposite directions in terms of rate policy. FedWatch tools and analysts are now predicting that the Fed will only cut one or two times this year. However, there has been some conversion in recent months and the Fed may have to raise rates one more time for them to cool inflation.

This contrasts to three or four cuts by the ECB by the end of the year.

Bonds, as we know, have an inverse relationship with interest rates. As yields fall, their prices rise. Investors look to lock in higher income as new comparable bonds come to the market with lower coupons. The sheer expectation of cuts has already started to push down yields for intermediate and longer-term bonds in Europe.

Just take a look at the fall in yield of Germany’s 10-year bond.



Source: WSJ

So, what does that mean? Investors have a chance to score some very good yields while gaining some capital appreciation. This is akin to a total return strategy for bonds, something that has been called ‘dead’ recently for U.S. bonds based on higher for long rates/inflation.

Moreover, rate cuts would reduce the amount of hedging and costs associated with holding foreign bonds by U.S. investors. This would exacerbate returns.

Investors have taken notice. Major institutional investors and investment banks such as PIMCO, J.P. Morgan, and T. Rowe Price have started to buy European bonds over U.S. Treasuries. In fact, investors have plowed more than $2.8 trillion into European bonds. That’s a record and more than five times the amount of issuance so far in 2024. 1

Focusing on Europe

Overall, U.S. investors tend to be underweighted international assets and are woefully underweight international bonds. However, they may want to consider adding European bonds to their portfolios.

Right now, investors have the ability to not only score a good yield, they also have the ability to realize capital gains. As the Fed continues to pause and even potentially raise rates, the ECB and other European central banks are prepared to cut rates amid their economic slowdowns. This will continue to push up the price of bonds, providing a strong total return effect for portfolios.

How to add them? Well, if you have a strong brokerage platform, it is possible to buy ECB bonds, U.K. Gilts, and other Eurobonds directly. However, that may not be in their best interest. Bid/ask spreads tend to be wide, while investors will need to hold euros or other currencies to make the transaction.

A better way? ETFs. While there isn’t a direct European bond ETF on the market, Eurobonds dominate many of the largest international bond ETFs. By using these, investors can have a similar effect and still gain much of their benefits, including the chance for price increases and good current yield.

International Bond ETFs

These funds were selected on their exposure to international bonds with a hefty focus on European issued securities. They are sorted by their YTD total return, which ranges from -5.1% to -1.8%. They have expense ratios between 0.35% to 0.50% and assets under management between $77M to $880M. They are currently yielding between 0% and 2.4%.

Overall, European bonds are offering a real chance at a good total return. The fact that the ECB and European central banks will have the ability to cut rates sooner than the Fed could mean that these bonds are a better current buy.

The Bottom Line

Investors are woefully underweight international fixed income assets. But they should rethink that stance. European bonds are currently offering a real chance of a great total return. Thanks to the ability of the ECB to cut rates sooner than the Fed, European bonds should see their prices rise. That’s great for current bond holders.

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May 23, 2024