Europe’s bond fund managers are scrambling to adjust their portfolios as Germany’s fiscal revolution triggered a dramatic move in government bond yields that spread as far as Japan. Expectations for future government spending in the eurozone and beyond are shifting rapidly, sending longer-term bond prices tumbling and sharply pushing up yields.
Some managers are selling longer-dated holdings, while others are buying to take advantage of the lower prices and higher yields. Others are shifting toward corporate bonds, which offer higher yields than sovereign debt but have recently been less volatile.
“The events in Germany were the most significant on the fiscal front in 40 years, but the selloff has been the sharpest in the period too,” says TwentyFour AM portfolio manager Felipe Villarroel.
Germany’s Fiscal Revolution and the Bond Impact
Yields on German government bonds have continued climbing after this week’s sharp spike, which follows the German government announcing a historic boost in spending and changes to the country’s “debt brake.” The increase in bond yields comes despite the European Central Bank cutting interest rates for the fifth time in a row and lowering its growth forecasts for the eurozone.
Yields on 10-year German Bunds are at 2.79%, a rise of 43 basis points from a month ago. Yields on French and Italian debt also rose, and the spread between Italy’s 10-year bonds and Germany’s is now hovering around 100 basis points, its lowest level since September 2021. The gap between Italian and German bonds is a key indicator because German bonds are believed to have the lowest risk in the eurozone. Japan’s 10-year borrowing costs also hit a 16-year high on Thursday at 1.52%, and yields on the US 10-year Treasury touched 4.32%. UK gilt yields on 10- and 30-year maturities also rose sharply.
How Fund Managers Are Reacting
“Longer-duration assets have felt the most pain,” Villarroel says. Duration is a key metric for bonds, measuring the sensitivity of debt to interest rates. The longer a bond’s maturity, the more likely it is that interest rates will impact its yields and prices.
Longer-maturity bonds (10 years and beyond) have borne the brunt of the recent selloff, pushing up yields at the longer end of the yield curve. The selloff creates a dilemma for managers: They can offload longer-dated or higher-duration bonds in case of further weakness, or add to their existing holdings.
“There’s a limit as to how high Bund yields can go before some market participants find yields attractive,” Villarroel says. “In portfolios where the Bund allocations were larger and longer, we have trimmed 10-year and 30-year Bunds, but we have not sold all of them. We have shortened our duration in EUR assets by selling some Bunds. We have added small amounts of EUR credit [corporate bonds]. This is a significant event for rates and spreads [between government and corporate bonds]. There’s reason to believe potential growth in Europe might be higher in the future, which means spreads could be tighter, all else equal.”
Some Managers Are Adding Longer-Dated Bonds
Antonio Serpico, senior portfolio manager at Neuberger Berman, thinks this selloff presents a buying opportunity for owners of eurozone government debt. “We have begun to rotate portfolios in this direction,” he says. “We have also begun to gradually add duration into portfolios, given that on the one hand, the announcement of the defense spending plan will have to be effectively implemented, and on the other hand, we are living in a context laden with uncertainty for economic growth, which could suffer further slowdowns from the tariff wars.”
Howard Woodward, co-manager on T. Rowe Price’s euro Corporate Bond strategy, sees signs of stability amid the selloff. “Despite this significant movement in sovereign markets, European corporate bond spreads [the gap between investment grade and non-investment grade bonds] remained stable, indicating good resilience in the investment grade segment,” he says. In times of economic stress, the yield spread between less-risky government debt and riskier corporate bonds widens, as does the spread between investment-grade and non-investment-grade or junk bonds.
A Stronger European Economy and Bonds
Investors worldwide demand more yield to buy debt following Germany’s historic spending plans, though this arguably reflects an improving outlook for Germany’s economy rather than concerns about the sustainability of its debt. Berlin has one of the lowest debt/GDP ratios in Europe at just 63%.
Goldman Sachs’ economics research team upgraded their German growth forecast materially, even assuming that spending will be scaled up gradually. “We raise our growth forecast by 0.2 percentage points to 0.2% in 2025, by 0.5 percentage points to 1.5% in 2026 and by 0.6 points to 2.0% in 2027 relative to our recently upgraded baseline,” they say in their latest paper released March 5.
Moreover, the fiscal news lowers the pressure for the ECB to reduce rates below neutral. Goldman Sachs no longer expects the governing council to cut at the July meeting, and it raised its forecast for the terminal rate to be 2% in June. It had previously forecast 1.75% in July.
What’s Next for Bonds?
“Overall, we expect markets to continue to price in some increase in supply and potentially an increase in the inflation premium”, says Annalisa Piazza, fixed-income research analyst at MFS Investment Management. She argues that markets may see more of the same, with longer-dated bond yields rising quicker than shorter-dated ones. “Steeper curves and some stabilization of yields at current levels are the most likely scenario for now,” she explains.
Yield curves reflect the different cost of debt for bonds across different maturities. “Obviously, fiscal changes are only one of the factors that move markets nowadays. The balance of risks that will come from fiscal support and the potential tariffs coming from the US from April will help to calibrate market pricing,” Piazza says.
What This Means for Yields and Growth
Serpico says, “The European rate market now has to deal with expectations of an abundance of government debt and therefore has to move to a higher yield range than in the recent past. At the same time, though, we believe that in the medium-term European rates should reflect the fundamentals of the economy, which include weak growth and declining inflation.”
While volatility is extremely high, a lot has been priced in over the last few days, according to Villarroel. “We expect Bunds to find some support in the 2.9%-3.0% area. Bunds hedged back to dollars are now amongst the highest-yielding developed government bond markets in the world.”
How Bond ETFs Have Responded to the Spike in Yields
Key eurozone and global government bond ETFs have been losing ground. Bond yields move in different directions from prices, so the sale of bonds has triggered a price fall and a rise in yields, which has impacted ETF returns.
The Xtrackers II Eurozone Government Bond UCITS ETF 1C XGLE lost 2.9% this week, while Vanguard’s EUR Eurozone Government Bond UCITS ETF VETY is down 1.6%.
Additional reporting by James Gard.