KEY POINTS:
- European credit is in demand, especially among investors looking to diversify their exposure to the US
- European macro conditions are supportive and the corporate sector is fundamentally resilient
- But volatility driven by uncertainty is becoming a more regular feature that investors must navigate
- Unconstrained strategies that actively manage credit and duration exposures are best placed to profit from this volatility
Increasing exposure to Europe was a consensus trade during 2025. Investors re-evaluated their positioning – notably US overweighting – in response to sudden changes of policy from the White House. Europe’s relative stability, together with its improving macro-economic environment and generally healthy corporate fundamentals, proved attractive and generated strong flows into European credit.
With some of the shocks that defined 2025 now receding, such as the volatility around US tariffs, Europe is likely to appeal to fixed-income investors in 2026 for its steady performance and attractive all-in yields. But that is not to suggest that uncertainty is about to disappear. Divergence between Europe and the US is likely to persist due to unpredictable US policy, which could contribute to greater volatility in European credit markets.
In this environment, the ability to react flexibly to fast-changing conditions – and to manage duration actively – is more important today than at any point in recent years.
The case for European credit
European credit brings several important benefits to fixed-income portfolios. The one that has stood out most recently is geographical diversification for investors looking to rebalance their long-term overweight of US assets and consequent large dollar exposure. Efforts to diversify in response to US policy shifts, particularly among non-dollar denominated investors, produced buoyant demand for European credit and kept spreads generally tight by historical standards.
This diversification trend has further to run and Europe is likely to remain a principal beneficiary. European fixed-income funds attracted over €360 billion in net inflows in 2025,1 reflecting the strength of investor appetite. Even after these inflows, investment-grade yields finished the year at around 3% and high yield at 5%+. At these levels, investors are supplementing the meaningful diversification benefits of European credit with solidly positive returns.
With the cost of dollar-hedging continuing to compress returns on US assets for international investors, the relative return argument for Europe is likely to remain relevant through this year.
European credit also has much to offer as a diversifier of equity risk. It represents a solid counterbalance to equity exposures that have performed well through 2025 – a year when the Stoxx 600 outperformed the S&P 500 for euro-denominated investors.
Alongside the portfolio diversification benefits that European credit brings, the fundamental case for owning it is solid. At the macro-economic level, growth remains positive in Europe while inflation has fallen back to the European Central Bank’s 2% target, with suggestions that it could dip temporarily below 2%. This makes interest-rate rises unlikely in the short term, which will tend to support bond prices. Europe is also embracing fiscal expansion, particularly through infrastructure and defence spending, which is likely to underpin the current combination of positive economic growth and modest inflation.
The outlook for Europe’s corporate sector appears reasonably positive. Companies across most sectors have adapted to the shocks from rising rates and energy prices. Balance sheets and margins are healthy and sectors such as banking have re-rated materially as confidence in their performance grows.
European bank equities rose by more than 55% through the first three quarters of 2025, underpinned by capital positions well above regulatory thresholds. For fixed-income investors, bank debt – and subordinated bank debt in particular – offers an additional advantage: a degree of insulation from the direct impact of US tariffs on global trade.
Although some industrials remain under pressure, corporate earnings growth overall is robust and demand for credit strong, both for refinancing and new issuance. European investment-grade supply rose by 10% to more than €600 billion in the first three quarters of 2025, yet thanks to continuing inflows, this increase was comfortably absorbed without a widening of spreads.
Arguments for an unconstrained strategy
Although the fundamentals for European credit are resilient, investors are operating in an environment that is more uncertain and more prone to swings in sentiment than they have been accustomed to.
European credit spreads ended 2025 around their tightest since the global financial crisis of 2007/8, but their progress through the final quarter was bumpy. Spreads widened across most sectors in November in response to uncertainty over the path of US interest rates and weakness in US equity indices, before tightening again in December. Shifts like this suggest that, even though the fundamental appeal of European credit remains supportive, uncertainty persist at elevated levels and investors therefore need to adjust to this evolving environment.
Portfolio managers have the scope to select issuers across sectors, regions and ratings as they seek to optimise returns and diversify risks. Free from the restrictions of a benchmark, they can tilt the portfolio towards more defensive sectors (such as utilities or telecoms) or cyclical areas (financials, real estate and industrials, for example) to reflect the economic outlook. They can also use derivatives to hedge or add specific risk to the portfolio in a capital-efficient way.
At the portfolio level, there are two key considerations for unconstrained strategies. First is the blend of credit quality that portfolio managers choose to optimise returns. This ranges from investment-grade bonds in core eurozone economies, through issuers in more peripheral markets such as Italy and Spain, to sub-investment-grade bonds that deliver higher yields but also increase potential volatility. Portfolio managers move flexibly between these risk allocations to optimise total risk-adjusted returns. The other key consideration for an unconstrained strategy is active duration management to mitigate interest-rate risk and capture opportunities created by changes in the market’s rate expectations.
Seizing the opportunities that volatility creates
An unconstrained total return approach is particularly appropriate for investors at this point. On the one hand, conditions in European credit markets are relatively favourable based on resilient fundamental and elevated yields compared to historical average. This argues strongly for an allocation to this part of the market, particularly for those seeking greater geographical diversification backed by historically attractive levels of yield, even as the broader spread environment remains cautious.
But volatility has a habit of resurfacing as economic and monetary policies pull in somewhat different directions between Europe and the US. This happened periodically through 2025 and can be expected to continue. That requires a strategy able to make opportunistic moves but also to adopt more cautious positioning as events dictate.
Volatility creates opportunities for investors able to capitalise on them. The ultimate value of an unconstrained credit strategy is that it hands managers the flexibility to take advantage during periods when markets change direction or over-react, seizing on value as it emerges. In effect, therefore, volatility becomes a catalyst for value creation, as much as a risk to it.
[1] Morningstar, as of 31 December 2025
Source: BNP Paribas Asset Management, March 2026
At the time of writing 27/2/2026, the Middle East conflict has not warranted any major changes to our base case macroeconomic outlook or investment recommendations. To follow our analysis of the events driving asset markets, go to Viewpoint at https://viewpoint.bnpparibas-am.com
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