With attractive yields and reduced currency risk, they may offer a viable option for both European and many Asian investors.

This abrupt shift is occurring against the backdrop of fading US exceptionalism, prompting a diversification of capital flows.

Euro corporate bonds gaining ground

US exceptionalism – the belief that US economic resilience, innovation and global financial dominance make its markets uniquely attractive and reliable for long-term investment – is starting to fade.

This will likely mean higher capital allocations by investors in Asia into investment-grade, euro-denominated corporate bonds, as this asset class offers a higher-yielding alternative to dollar-denominated debt.

We’re expecting more interest from Asian investors, and especially those in Japan, seeking diversification and yields. Investors from this region are under-represented within this asset class and there are further opportunities for growth.

Similarly, we expect European investors to reduce their US dollar allocations due to high hedging costs, political uncertainty in the US and attractive yields of more than 3% available closer to home.

Many European investors had looked beyond the continent in recent years for a solution to low interest rates back home. This outward flow of capital will reverse, amid improving domestic yields that can be achieved without hedging costs or exposure to currency risk (see Chart 1).

Hedging costs are the price investors pay to protect themselves against currency fluctuations when they invest in assets denominated in a foreign currency.

In recent years, the euro-denominated corporate bond market has grown to some €3.2 trillion (US$3.8 trillion) in market value, roughly 40% the size of the US dollar corporate bond market. Its breadth and depth mean it has become investable for many investors.

Over the shorter term, lower corporate bond issuance during the northern hemisphere’s summer months will provide further support for performance.

We’ve seen credit spreads – the difference in yield between corporate bonds and government bonds of similar maturity – recovering since a big bond selloff in April, but still offering a reasonable premium above government bonds, supported by strong corporate fundamentals.

Overall, we think euro corporate bonds offer attractive value for investors – with yields of more than 3%, significantly above the average for the past decade.

Fading US appeal

The US has enjoyed a long period of ‘exceptionalism’ – characterised by economic strength, innovation, the dollar’s reserve currency status and global influence – that’s attracted tremendous capital inflows.

However, this privilege is beginning to fade due to a deteriorating outlook for growth, rising government debt, political polarisation and foreign policy decisions that have alienated allies.

Right now, foreign investors – especially those from Europe and Asia – account for some 25% of the US corporate bond market. While the US will likely remain the world’s dominant capital market, we do expect foreign investors to diversify away from their current allocations for four reasons:

During the first half of this year, while US corporate bonds returned 4.2% in dollar terms, the asset class was down 8.06% for an investor whose base currency is euros, and down 4.23% for someone whose base currency is yen, according to ICE BofA US Corporate Index data.

This performance was due to a falling US dollar, which lost 14% against the euro and 9% against the yen over this period. With dollar weakness likely to persist, returns on dollar-denominated assets held by foreign investors will continue to be eroded.

Foreign investors usually protect their dollar-denominated bond investments using three-month foreign exchange forwards, which are based on the short-term interest-rate difference for a currency pairing.

A forward is a type of contractual agreement between two parties to buy or sell an asset at a specified future date, for a price agreed upon today. As interest-rate differences increase, the costs of hedging against currency movements also go up.

Final thoughts

For European investors, euro corporate bonds now offer attractive yields without the need to hedge currency risk. Asian investors, traditionally underexposed to euro-denominated assets, may find the market’s growing depth and breadth appealing.

As hedging costs rise and US policy uncertainty persists, reallocating to euro corporate bonds could enhance portfolio stability and returns.