Seizing opportunities in European fixed income amid fiscal expansion
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Key takeaways
- The European fixed income landscape is evolving, driven by prospects of fiscal easing, shifting central bank policy, and changing market expectations.
- Markets have reacted by pricing in a less dovish ECB, with expectations shifting toward a higher terminal rate than previously anticipated and a slower pace of monetary easing.1
- Despite rising yields, we believe longer-duration bonds remain appealing as the ECB continues cutting rates, while investment-grade credit offers stable income potential backed by strong corporate fundamentals.
Introduction: A shifting landscape in European bonds
In Europe, the unprecedented prospect of fiscal easing in Germany has shifted the market narrative from a focus on the region’s structural weaknesses to a more optimistic outlook for medium-term growth.
Germany intends to establish a €500 billion infrastructure fund and to relax its constitutional borrowing constraints to allow for increased defence spending. This development aligns with the broader transition within the European Union, which has officially entered a “rearmament era” and is advocating for higher expenditures to strengthen its defensive capabilities. In 2024, EU Member states' defence spending reached around €326 billion, or about 1.9% of the region's GDP.2 Reaching 3% - 3.5% of GDP would require a major additional budgetary effort for the EU, between €200 billion and €275 billion.3
These announcements are a game changer for Eurozone medium-term growth. The German infrastructure plan appears promising for the German economy and, by extension, for Europe. Over a ten-year horizon, Berlin plans to spend €50 billion annually—an amount equivalent to roughly 1.2% of Germany’s 2024 GDP.4
Against this backdrop, additional fiscal spending on infrastructure and defence means a steep rise in funding needs—and, in Germany’s case, a noticeable increase in Bund issuance. Taking into account the budget for defence spending and the infrastructure plan, Germany’s annual financing needs are expected to increase by between €250 billion and €325 billion over the coming years.5
Meanwhile, the European Central Bank (ECB) has adopted what it terms an “evolutionary policy approach”. The tumble in German bonds, driven by spending plans, and the global uncertainty, fuelled by Trump’s policies, are creating a complex environment for monetary policymakers. At its most recent meeting, ECB President Christine Lagarde emphasized that the institution is contending with both downside and upside risks to inflation, underscoring the heightened degree of uncertainty. The ECB has thus reiterated its data-dependent stance, acknowledging that the pace of unfolding events leaves little room for complacency.
Government bonds: Navigating a new fiscal environment and rate cuts
Germany’s ambitious spending plans are already affecting European bond markets. Following the announcement of large-scale fiscal expansion, Bund yields surged by 50 basis points in just two weeks as investors adjusted to expectations of higher growth, medium-term outlook of higher inflation, and increased government borrowing.6 This has resulted in a steepening of the European yield curve, as longer-term bond yields have risen more than short-term rates.
Markets have also reassessed their expectations for European Central Bank (ECB) policy. Initially, a more aggressive rate-cutting cycle was anticipated as inflation eased, but higher government spending and trade uncertainties have led investors to price in a less dovish ECB. The expected terminal rate has now been revised upward to 2%, with higher rate expectations extending into 2026 and 2027.7
Why we see opportunities in longer-duration bonds
Even though bond yields have risen recently, we believe longer-duration bonds remain appealing. We expect the ECB to continue cutting interest rates, which typically supports bond prices. Additionally, yields remain high compared to recent years, making this a potentially favourable time to lock in yields before rates fall further.
It’s also worth considering that global risks, such as trade tensions or slowing economic growth, could drive investors back into safe-haven assets like government bonds, supporting prices.
Investment-grade credit: Solid fundamentals and yield potential
Alongside the opportunities in sovereign bonds, we believe investment-grade corporate debt is an option to consider for investors seeking stable returns. While government bond yields have risen, corporate bonds continue to offer strong income potential, supported by healthy company fundamentals and steady investor demand. Many businesses in the Eurozone have low debt levels, solid profitability, and disciplined financial management, making them well-positioned to navigate changing market conditions. At the same time, many companies are proactively refinancing their debt ahead of upcoming maturities, taking advantage of stable funding conditions to strengthen their financial positions.
Investor appetite for corporate bonds remains strong, with steady demand for European credit markets. While credit spreads have tightened, carry (the income earned from holding bonds) remains the key driver of returns, providing investors with a reliable source of income. With high-yield bonds, in our view, less attractive due to tighter spreads, investment-grade credit continues to offer a compelling balance of stability and income generation, making it a potentially strong complement to government bond exposure.
Conclusion: Finding opportunities in a changing fixed income market
Amid rising EU-wide defence spending, Germany’s historic fiscal shift, and ongoing ECB rate cuts, European fixed income presents interesting investment opportunities:
- We believe longer-duration government bonds are appealing, as rate cuts continue to support fixed income markets despite rising issuance.
- Investment-grade credit offers stability and income potential, backed by strong corporate fundamentals and steady investor demand.
As European debt markets evolve, staying positioned for quality assets will be key to navigating this changing environment.
Access the opportunity
1. European Central Bank. “ECB Economic Bulletin – March 2025.” ECB.europa.eu, 2025
2. Council of the European Union. “Defence in Numbers.” Consilium.europa.eu, 2024.
3. Financial Times. “European Countries Face €275 Billion Budget Challenge to Meet Defense Targets.” FT.com, 2024
4. Reuters. “Germany’s Fiscal Expansion Would Boost GDP by 2026, DIW Says.” Reuters.com, 14 Mar. 2025.
5. CBS News. “Germany Approves €1 Trillion Spending Package, Including €500 Billion for Infrastructure.” Cbsnews.com, 2025.
6. Reuters. “German Spending Boost to Leave Lasting Impact on Global Bond Markets.” Reuters.com, 10 Mar. 2025.
7. Amundi, Bloomberg, as at 25 March 2025.
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