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        Weekly ETF Brief

        Yielding Power: What Militarizing Europe Means for its Bond Markets

        Germany’s new and more expansive fiscal position to fund the new European security realpolitik transforms the region’s bonds outlook. The yield curve has steepened but it can steepen further. Lodging at the front end of the curve is justified by the defensive nature of short-duration strategies, and continuing protection from the European Central Bank’s easing cycle.

        5 min read
        Jason Simpson
        Senior Fixed Income ETF Strategist

        Europe Conscripts its Bond Markets

        Germany’s lawmakers loosened fiscal rules to release defence funding from the country’s historic constitutional brake on spending, and simultaneously announced an additional €500B for infrastructure renewal, in a transformational moment for Europe. The EU is also set to raise €150B in military development loans. There is nothing like an old-fashioned bit of fiscal stimulus to boost growth expectations — and European equities have benefitted enormously from the improvement in sentiment.

        The news has not gone down as well in debt markets, which have to fund the borrowing. The benchmark 10Y German Bund yield started the year at 2.37% but has since shot up to over 2.75%1. Real yields have notably pushed higher, with 10Y breakevens rising, although no higher than other peaks over the past year. This indicates that the bond market is pricing in better levels of underlying economic growth over an inflation pick-up. The bellwether 5-year, 5-year forward inflation swap rate has also remained relatively well contained.

        The calm is a fiscal judgement. The curve has steepened in anticipation of the increased supply. Initially this was in the belly of the curve, which saw the long end slope flatten, but steepening has also now percolated down the curve, beyond the 10Y point.

        Further Steepening Risks

        The German yield move has been sharp, exaggerated by the fact that investors were overweight German bonds coming into the quarter, as we detailed in the investor sentiment section of our Q1 2025 Bond Compass. However, real risks of further steepening remain as supply comes on stream, not just in the form of German bonds, but also higher issuance from other EU nations and the EU itself. In addition, the German curve remains relatively flat in historical terms

        Figure 1 shows the German 2-10 year spread plotted against the 1-year rate. This should provide an indication of how flat/steep the spread is relative to the front-end yield, over different periods of history. What is notable is that the German 2-10 year spread remains flat even relative to the curve shape during the 2008 Global Financial Crisis (GFC), when front-end yields were last at similar levels. This is in part the result of years of European Central Bank (ECB) bond buying, but also because of German fiscal rectitude. In contrast, the US and UK 2-10 year spreads have returned to their pre-GFC steepness levels.

        Figure 1: German Bonds: Stirred, Not Shaken, by Military Commitments

        German 2-10Y Spread Still Flat vs 1Y Compared to 2008

        Figure 1 shows how German bonds have responded to new fiscal rules versus recent history.

        The Euro Curve: Focus on the Front End 

        It’s logical to focus on the front end of the euro curve in light of risks that the curve could drift steeper. There is a yield sacrifice, but this can be mitigated by investing in investment grade (IG) credit rather than government bonds. There are three reasons why short-end exposures could benefit investors:

        1. The ECB continues to cut interest rates, which should provide some protection to the front end. Around 50 basis points (bps) of cuts are already priced for the remainder of 2025, and the ECB has been relatively consistent with its monetary easing message. Conversely, longer-dated maturities could see yields rise if the US economy strengthens.
        2. Yields at the front end of the curve may be lower but, from a risk/reward perspective, this is more than offset by their shorter duration, which makes them less sensitive to rate moves. For instance, the breakeven rate of the Bloomberg 0-3 Year Euro Corporate Bond Index is 190 bps versus 75 bps for the all-maturity Bloomberg Euro Corporate Bond Index.2 In other words, yields on the short 0-3 year index would have to move over 100 bps higher than the all-maturity index can sustain before the price losses outweigh the annual yield from holding the index.
        3. The front end of the euro IG curve looks better value from a spread perspective. Spreads for the Bloomberg 0-3 Year Euro Corporate Bond Index are 1.41 deviations rich to the 12-month average against 1.67 for the Bloomberg Euro Corporate Bond Index. On a longer-term basis, current spreads are 27 bps rich to the 5-year average for the 0-3 year index versus over 40 bps for the all-maturities.3

        Any conversation on short duration should also include high yield exposures. The Bloomberg Liquidity Screened Euro High Yield Index has a duration of 2.5 years and yield-to-worst of 5.35%, which combines to give a breakeven of over 200 bps. This level of protection and the backdrop of potentially stronger growth driven by fiscal stimulus suggest maintaining high yield exposures.

        How to Access the Theme

        SEUA GY

        SEUA GY

        SPDR® Bloomberg 0-3 Year Euro Corporate Bond UCITS ETF (Acc)

        View Fund Details

        SYBD GY

        SYBD GY

        SPDR® Bloomberg 0-3 Year Euro Corporate Bond UCITS ETF (Dist)

        View Fund Details

        SEGHX I2

        SEGHX I2

        SPDR® Bloomberg 0-3 Year Euro Corporate Bond GBP Hdg UCITS ETF (Dist)

        View Fund Details

        SEHAX I2

        SEHAX I2

        SPDR® Bloomberg 0-3 Year Euro Corporate Bond USD Hdg UCITS ETF (Acc)

        View Fund Details

        SYBJ GY

        SYBJ GY

        SPDR® Bloomberg Euro High Yield Bond UCITS ETF (Dist)

        View Fund Details

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