Euro credit: what might starting yields tell us about future returns?

Investors can’t control what happens next to interest rates, inflation or credit spreads. But they can assess the starting point. For euro investment grade (IG) credit, that point has changed significantly. Yields are currently above 4%, providing investors with substantially more income than was available for much of the previous decade.

That doesn’t guarantee strong returns. Markets rarely offer that kind of certainty. But history suggests the yield available when investors enter the market can make a meaningful difference to what follows.

A good place to begin

After several years of higher inflation, rising interest rates and heightened economic uncertainty, European bond markets look very different from the ultra-low-rate environment of the 2010s.

Euro IG yields are currently above 4%. Levels of 4% or more have occurred in less than a quarter of the monthly observations over the period analysed, making today’s starting point relatively unusual by recent standards.

For investors, that means more income and less reliance on bond prices rising or credit spreads tightening.

What does history show?

The chart below compares subsequent one- and three-year returns from different starting yield levels.

Periods when euro IG yields started at around today’s levels were relatively uncommon but were generally followed by stronger returns than periods when yields began below 4%. The relationship was clearest over three years, when every period beginning with a yield above 4% produced a positive return.

Shorter-term outcomes were less consistent, showing that higher starting yields do not remove volatility. However, the data suggests they can provide a stronger foundation for returns, particularly over longer holding periods.

Why does the starting yield matter?

A bond’s return can come from several sources. Its price may rise if interest rates fall or its credit spread tightens. But investors also receive income simply by holding the bond. That income is known as carry: the return earned over time from holding an investment, assuming other market conditions remain broadly unchanged.

When starting yields are low, investors may need bond prices to rise to generate an attractive total return. This creates greater dependence on movements in interest rates and credit spreads.

A higher starting yield changes that balance. Carry plays a greater role in potential returns and can provide a cushion against modest price declines.

What happens if rates move?

The future path of interest rates remains uncertain. But rather than relying on one forecast, investors can consider how euro IG might behave under several scenarios.

If interest rates fall, investors could benefit from the income generated by the bonds and the positive effect that lower yields typically have on bond prices.

If rates remain broadly unchanged, carry is likely to do most of the work as investors continue to collect income.

If rates rise, bond prices may come under pressure. However, today’s higher starting yield provides a larger income cushion than investors had during the ultra-low-rate era, helping to offset some of the impact.

Interest-rate sensitivity has also fallen. As the chart below shows, the average duration of the euro IG asset class is now much lower than it was during the peak quantitative easing period, partly reflecting today’s higher coupons and yields. Investors are therefore being offered well-above-average yields with less sensitivity to changes in interest rates than during that period.

 

Final thoughts…

The past cannot tell investors exactly what will happen next. But it can provide perspective. With euro IG yields above 4%, investors are receiving a level of income that has been relatively uncommon in recent history. That means returns may be less reliant on falling rates or further spread compression.

The outlook remains uncertain. Today’s starting point, however, gives investors more to work with.