The backdrop for Europe’s bonds remains favorable—even as technological change creates new challenges.
Across the UK and euro area, we see scope for further interest-rate cuts to support government bonds in the year ahead. In Europe’s credit markets—both investment grade and high yield—we think the positive factors that have driven strong 2025 performance remain in place. Meanwhile, technology—and the potentially transformational effects of AI—may present new risks and opportunities for European fixed-income investors in 2026.
The Case for Lower Rates
While the market is looking for UK interest rates to fall further in 2026, it expects that euro-area rates have stabilized and that the next move will be up. We disagree.
Several factors threaten to push euro-area inflation below the 2% target, for instance: formerly sticky wage and services inflation continue to slow; the euro remains strong, hurting Europe’s exporters; and after the trade wars, Chinese exports are rerouting from the US to Europe and depressing prices.
The European Central Bank (ECB) sees deviations from its inflation target as temporary and expects higher levels of economic growth, supported by increased German fiscal spending, to trigger an upward reset of euro rates. But we think growth may remain subpar or around trend at best, and we don’t see strong evidence to support a higher neutral interest rate in the eurozone.
The upshot? In our view, the possibility of further stimulus from one or more ECB rate cuts in the year ahead.
We expect lower rates to have the most positive impact on the short- and mid-dated parts of the UK and euro area government-bond yield curves, as the longest maturities will likely feel upward pressure from big deficits—both at home and abroad.
Valuations Are Attractive
While the eurozone’s tight credit spreads are concerning for some, we don’t think narrow spreads should deter investors from owning credit. The best predictor of future total returns remains current yields, not spread, and with investment-grade yielding 3.1% and high yield 5%, we see potential for attractive returns for buyers at these levels.
For instance, in the high-yield market, BB-rated bonds—the highest quality part of high yield—offer above 4% yield, which is equivalent to the annualized return of the whole euro high-yield market over the last 10 years.
Demand for Credit Set to Stay Strong
We think demand will be strong across credit markets in 2026. In the hunt for income, we expect continuing flows out of money markets into credit—particularly if rates are cut again. In addition, the EU defense and German infrastructure packages could provide further growth tailwinds, which we believe will be supportive across the credit curve.
Investors concerned by potential equity volatility resulting from tech stocks’ demanding valuations and vertiginous capex spend may also want to reduce equity risk by allocating more to credit, especially to shorter-dated high-quality investment grade. We believe active security selection may be especially important here, as both the productivity benefits and competitive challenges from AI will likely be initially distributed unevenly across sectors and companies.
On the supply side, a more uncertain macroeconomic environment paired with higher borrowing costs will likely make European companies warier of launching debt-financed acquisitions and major capex programmes. We think this demand/supply imbalance is set to provide a powerful boost for credit markets in 2026.
Credit Fundamentals Remain Supportive
Credit fundamentals are still robust. For instance, in investment grade, net leverage is only slightly above the long-term average and interest coverage only slightly below; asset quality is still benign; liquidity continues to be strong; and margins are mostly solid, with erosion evident only in some cyclical sectors.
High-yield credit fundamentals appear comparable, but with an added attraction for risk-conscious investors: the market’s average duration is a lot shorter at 2.9 years. That makes euro high yield less sensitive to interest-rate changes than many other fixed-income sectors. In a downturn, yields would need to rise by almost 2% to wipe out a high-yield investor’s income.
At the same time, high-yield maturities are gradually extending, signaling that companies are successfully refinancing and pushing out their debt profiles. This helps reduce near-term default risk and supports overall credit stability.
