Flash Fixed Income: Guilty by association?

It has been an uncomfortable autumn for fixed income investors, with extreme volatility in government bonds telling us uncertainty is high.

One notable trend has been the divergent performance of the US and European credit markets in response to the broad sell-off in rates. Having spent most of the year moving in lockstep, US investment grade (IG) corporate bond spreads have barely flinched while European spreads have widened. Euro IG may have shown far more resilience than the region’s government bonds, and spreads do remain tight by historical standards, but it has underperformed the US despite there being little evidence of any comparable deterioration in the underlying health of European companies.

These apparently contradictory signals raise an important question for fixed income investors: when government finances deteriorate, how much of that risk should be priced into the borrowing costs of otherwise healthy businesses?

A global rates shock with uneven impact

As the US-Iran conflict has failed to de-escalate as hoped in the approach to the US midterms, squeezing energy prices and inflation, government bond yields have surged. Central banks are expected to continue tightening monetary policy, putting pressure on the front end of yield curves. Some economic activity data has been firm, but non-farm payrolls data showed the US economy added just 29,000 jobs in September.¹ With the sustainability of public finances in focus and longer term US Treasury (UST) supply forced to compete with the absorption of hundreds of billions of AA-rated hyperscaler debt, we think investors are demanding a higher real return for lending to the US government, rather than simply pricing more inflation. Real yields have risen along with term premium, with the 10-year UST yield reaching 5.36% earlier this month, its highest level since April 2002.

Volatility has been highest in rates. The MOVE index, which measures expected volatility in UST yields, has been hovering around 116, close to its 2026 high in March, while the VIX index, which measures expected volatility on the S&P 500, has stayed near its lows for the year. Equity markets have largely looked through the turmoil, with the S&P 500 still up 11.9% for the year despite a difficult week for technology stocks. 

The rates volatility has not been contained to USTs. Thirty-year UK Gilts have hit 6%, their highest yield since 1998, while 10-year German Bunds have reached 5.36%, a level not seen since 2008.

In our view, the global rates shock cannot by itself explain why European credit underperformed. The March sell-off at the start of the Iran war offers a useful comparison: US and euro IG spreads spiked together on that occasion, peaking within a couple of basis points (bp) of each other. Global risk aversion tends to affect both markets equally.

This time, while Bunds managed to outperform USTs during the recent sell-off, sovereign performance within Europe was not uniform. The volatility amplified growing investor concerns over France’s fiscal trajectory, and the political difficulties associated with putting public finances on a more sustainable footing. The government’s 2027 budget did little to reassure. Even if every measure is delivered, the deficit is only projected to fall from 5.4% to 5.0% of GDP, while public debt is forecast to climb to 121.7% of GDP. The market has effectively dispensed with any 'risk-free' status French government bonds (OATs) still held, with the OAT-Bund spread recently touching 150bp, a larger premium over Germany than both Italy and Greece. 

Italy has also experienced pressure. Its 10-year government bond yield rose nearly 50bp during September, reflecting both the global adjustment in yields and concerns over the sustainability of its substantial public debt. However, the challenges facing these countries are not identical. France's political difficulties have been particularly acute, while Italy's fiscal position, despite its high debt burden, has benefited from greater political stability and a relatively disciplined recent budgetary approach.

For years, investors became accustomed to treating Eurozone government bonds as part of a relatively homogeneous market, distinguished principally by modest differences in credit quality and liquidity. Recent developments are a reminder that sharing a currency does not mean sharing a fiscal position.

European credit has diverged from the US

Despite the substantial increase in UST yields, US IG credit spreads widened just 4bp during September (as measured by the ICE BofA US Corporate Index), virtually ignoring the shift in underlying yields. European IG experienced a more noticeable deterioration, with spreads widening 12bp in September (as measured by the ICE BofA Euro Corporate Index) and financials and subordinated insurance bonds among the areas experiencing the greatest pressure.

Having moved in tandem with the US for most of the year and ending the summer trading slightly tighter, the divergence of European IG has persisted into October (see Exhibit 1). 

We should highlight that the above indices are made up of USD and euro denominated debt rather than exclusively US or European issuers (US issuers accounts for nearly 20% of the euro index). However, we believe the geographic bias is sufficient for the relative performance to be meaningful.

What makes the contrast particularly interesting is the absence of evidence that European corporate fundamentals have deteriorated sufficiently to explain the difference in market performance.

European companies undoubtedly face challenges, from elevated energy costs and subdued growth to the gradual refinancing of debt issued at much lower interest rates. However, these pressures are not new, nor have they suddenly translated into a widespread deterioration in credit quality.

If the market believed credit conditions had materially worsened in Europe, we would expect this to be reflected most acutely in high yield (HY) corporate bonds, particularly in the lower rating brackets containing the weakest borrowers whose balance sheets are generally more vulnerable to economic and financing pressures. This is where concerns about default risk would typically materialise first. But the HY index data does not show this pattern (see Exhibit 2). During September, overall European HY spreads widened by 41bp, compared with 48bp in the US. European B and CCC rated spreads widened 37bp and 66bp respectively, against 45bp and 135bp in the US.

Seeing Europe's relative underperformance was concentrated in IG leads us to believe it reflects the transmission of government bond volatility into corporate credit, amplified by weaker market technicals. In effect, European credit has become guilty by association.

How much sovereign risk should credit carry?

Banks provide one of the clearest examples of how rates market turbulence can affect corporate borrowing costs without necessarily signalling a comparable deterioration in creditworthiness.

When investors become concerned about a government's finances, the pressure frequently extends to its domestic banks. These institutions depend on wholesale funding markets, making them particularly sensitive to changes in market confidence, liquidity and investors' willingness to provide capital. Even where balance sheets remain healthy, greater sovereign volatility can lead investors to demand a higher risk premium on bank bonds, particularly subordinated securities, and make access to new funding more expensive or less reliable.

This relationship is not entirely disconnected from fundamentals. Sovereign downgrades can affect bank ratings, higher funding costs can squeeze profitability, and fiscal pressures can eventually weaken domestic economic conditions. However, these risks need not imply an immediate or proportionate deterioration in banks' financial strength.

Indeed, in France, the country's largest lenders have relatively modest direct exposure to French government bonds and benefit from substantial international diversification. Combined with strong capital and liquidity positions, these factors provide considerable protection against the immediate consequences of sovereign volatility. Nevertheless, the market will continue to demand additional compensation for holding their bonds while uncertainty persists. 

The confidence relationship is clearest in banks given ongoing market access is such an important component of their health, but sovereign stress can bleed into risk appetite for non-financials as well.

Investors often respond to heightened sovereign risk by reducing their overall exposure to a country or region. This can involve selling corporate bonds alongside government debt, regardless of whether an individual company's credit fundamentals have changed.

Fund flows illustrate how these pressures can develop. Data from EPFR shows European-domiciled IG bond funds experienced outflows of approximately $2.7bn in the week ended 16 September, followed by a further $1.9bn of withdrawals in the final reporting week of the month.

Fundamentals tell a different story

None of this reflects a meaningful deterioration in European corporate credit quality, in our view. The European Central Bank's (ECB) latest supervisory statistics, covering the second quarter of 2026, show that significant euro area banks had an aggregate Common Equity Tier 1 capital ratio of 16.0%, while their return on equity reached 10.7%, the highest recorded since the supervisory series began in 2015. Non-performing loans remained low at 2.17%, while the liquidity coverage ratio stood at approximately 155%.

In European HY, the default rate fell to 0.5% in September, its lowest since July 2023 and half its 10-year average. Rating migration has been benign.

European credit is also largely free of the pockets of stress that are troubling the US. The weakest US borrowers, and some of the heaviest AI-related issuers, have seen their spreads widen sharply. In IG, the hyperscalers account for around 5.5% of the US index but just 1.3% of the European, with net supply of $130bn (€115bn) vs. €22bn respectively year-to-date, according to Bloomberg data.

Relative value in European credit?

The evidence suggests to us that European corporate credit has been repriced because of the market in which it trades, rather than a broad reassessment of the ability of its issuers to repay their debts. This doesn't necessarily make the widening unjustified; investors can reasonably demand additional compensation for sovereign uncertainty and market volatility even if expected corporate default losses have barely changed.

Nor does the relative strength of corporate fundamentals guarantee a reversal. If sovereign volatility persists, European credit spreads may remain under pressure regardless of the health of individual borrowers. Indeed, further fiscal deterioration and sustained pressure on government bond markets could push corporate spreads wider.

However, we think it is important to note that government borrowing problems can be contagious for bond prices without necessarily being contagious in credit losses. 

For active investors willing to look globally this difference creates opportunities. Fundamental credit analysis can help determine whether a company's bonds have become cheaper because its financial position is deteriorating, or because it has been caught up in broader market risk aversion. 

Examining cashflows, balance sheet strength, refinancing requirements and exposure to domestic economic conditions can allow investors to distinguish between issuers genuinely vulnerable to sovereign difficulties and those whose bonds have widened largely through association. 

Quick capital gains might not be on offer, but the chance to pick up additional spread without a corresponding increase in underlying credit risk can improve medium term returns. However, it is important for investors to understand where potential drivers of volatility sit. Higher return potential needs to be balanced against careful consideration of position sizing, liquidity and timing.