Key Takeaways
- The spread between short- and long-term government bonds has widened, steepening the yield curve.
- Concerns about the sustainability of public debt, particularly in France and the US, together with Dutch pension fund reform, may lead to further bond price declines and, consequently, an increase in yields.
- Fund managers prefer debt with short and medium terms, as well as peripheral government bonds.
The eurozone bond market enters the fourth quarter with no illusions about further interest rate cuts by the European Central Bank in the final months of 2025. But there are also very real fears that the French crisis could damage the area’s economy and the financial institutions and bring further volatility to fixed income.
The Morningstar Eurozone Treasury Bond Index, which measures the performance of euro-denominated government bonds with a maturity of more than one year, is up 0.41% since January. It was hit in January, March, and again in September, when concerns about the sustainability of France’s public debt increased.
The most immediate effect was the steepening of the government bond yield curve, which marks an increase in the spread between long-term and short-term bond yields. It is because investors are demanding a higher premium to hold long-term securities. Fears about public spending, which is expected to increase to support defense and infrastructure spending in the eurozone, are pushing markets to continue to demand a higher risk premium, which in turn accentuates the steepening of the curve. In France, for example, the debt/GDP ratio has risen from 95% in 2015 to currently 110%.
During the pandemic, the yield curve was flat, if not inverted, due to ultra-expansionary monetary policies to support growth, with negative yields on both the short and long ends. The yield of the 30-year German bund, a benchmark for the eurozone, rose from 3.00% at the end of May to 3.33% at the end of September, with a spread of 1.33 percentage points over two-year bunds.
A rising yield spread between short and long-term bonds, also known as a steepening yield curve, can indicate investors’ uncertainty about the long-term sustainability of a debt instrument.
In the same period, the French 30-year bond yield’s increase has been even more pronounced, rising from 3.92% to 4.35%, with a spread of 2.22 percentage points over the French two-year bond.
Could the Bond Yield Curve Become Even Steeper?
Rating agencies are reviewing their ratings for countries in the euro area, with France seeing its sovereign debt rating downgraded by Morningstar DBRS and Fitch, while Italy has been upgraded by Fitch and is awaiting updates from other rating agencies, including Morningstar DBRS on Oct. 17.
“Further difficulties in approving the [French] budget law could lead to additional pressure on the market with a further widening of the government spread, also involving the banking sector,” says Massimo Spagnol, fixed income portfolio manager at Generali Asset Management.
The European bond market could also suffer repercussions from fears about the sustainability of US public debt, which, according to Spagnol, could produce higher rates on longer maturities.
Further difficulties in approving the [French] budget law could lead to additional pressure on the market with a further widening of the government spread, also involving the banking sector
Massimo Spagnol, Generali Asset Management
The reform of Dutch pension funds could also push in this direction, because from 2028 fixed income will no longer be its backbone. The reform shifts the system from one of defined benefits, where pension income amounts were guaranteed, to a defined contribution model, where contributions are invested, giving retirees a pot of money to use when they retire.
Under the previous system, long-term government bonds worked very well to guarantee a certain income, but under the new system this will no longer be the case, so it is estimated that in the coming years, Dutch pension funds will sell EUR125 billion worth of 30-year government bonds, about half of which will be from Germany, France, and the Netherlands, putting further pressure on yields.
Are Italy, Spain, and Greece Still on the Periphery?
Despite France’s difficulties and volatility in the bond markets, Italian government bonds, considered among the riskiest, have shown remarkable resilience, and the spread between 10-year Italian BTP and 10-year German bund has fallen to a 15-year low.
“The eurozone periphery, once synonymous with high debt, soaring unemployment, political instability, and estrangement from Brussels, has undergone a remarkable transformation,” says Neil Mehta, portfolio manager at RBC BlueBay.
Italy has found a degree of stability, Greece has regained investment-grade status, Spain has emerged as one of Europe’s fastest-growing major economies, and Ireland has deepened its ties with the EU in the post-Brexit era. “The distinctions between core and periphery have never been less pronounced, reflected in a mere 60 basis points gap [as of Sept. 16] between the widest and tightest eurozone sovereign bond spreads.
Mehta does not see any risks of a eurozone crisis like the one in 2011 on the horizon, but warns that periods of policy stagnation combined with thin market liquidity “can still trigger sharp, and outsized price movements.”
How Are Fund Managers Positioning Themselves for the Fourth Quarter?
“Yield curves have steepened, making bonds more attractive than cash,” says Maria Paola Toschi, global market strategist at J.P. Morgan Asset Management, adding that “the negative correlation between bonds and equities is once again beneficial to portfolio construction. Positive real yields offer protection in the event of a weaker-than-expected economy. The medium-short part of the curve offers a better risk/return mix.”
Yield curves have steepened, making bonds more attractive than cash.
Maria Paola Toschi, JP Morgan Asset Management
Spagnol of Generali Asset Management is “moderately positive on duration, with an allocation that focuses on the middle part of the curve up to 12 years.” The end of the monetary cycle and potential pressure on long-term securities mean that the manager prefers to underweight short- and long-term bonds.
Duration is a measure of interest rate sensitivity, and longer-term bonds have greater durations than shorter-term ones, as their cash flows are further away in time, making them more sensitive to discount rate changes. Longer-duration bonds can offer more yield, but they also carry risks if rates rise and the value of those bonds falls.
“We are constructive on Italy and Spain given the positive sentiment characterizing the two countries. We are more cautious on Germany given the risk of a potential increase in bond issuance, as happened in the previous quarter.”
Spagnol says that credit, particularly investment-grade credit, represents “an excellent source of return with an acceptable level of risk,” while riskier assets “should be monitored closely between now and the end of the year,” given the levels reached and the geopolitical and economic risks.
While credit risk may currently be preferable to duration risk, Alessandro Tentori, chief investment officer for Europe at AXA Investment Managers, says that investors will have to address the “essential issue” of price in the future. “With the yield curve steepening, relative to risk-adjusted credit spreads, the attractiveness of duration relative to credit spreads will increase. At some point, duration will once again become an attractive alpha driver.”
