Why US Dollar-Based Bond Investors Should Look to Europe

Rising US deficits and debt, coupled with less predictable policy, have created anxiety about US exceptionalism and spurred bond investors to re-examine their diversification options away from US assets. While no other capital market offers the depth and liquidity of the US and there’s no single credible replacement for US Treasuries, we believe that there’s a case for considering an increase in ex-US exposure. Europe is a prime candidate: its bond markets have grown, are high quality and may benefit from a fall in yields. And as European markets are considerably smaller than the US’s, even a small shift in US investors’ allocations may make a significant price difference.

European Markets: Credibility Meets Opportunity

The euro is second-largest in the world’s central bank reserve managers’ currency holdings, currently at 20% of total (Display), down from a peak of around 30%. If investors start to rotate out of US dollars (USD) into euro, that could contribute to the euro appreciating against USD.

De-Dollarization? Euro Could Benefit

Current analysis and forecasts do not guarantee future results.
As of April 10, 2025
Source: Bank of America Global Research, Bloomberg and IMF

Three major issues driving previous euro weakness have been fixed: following the resolution of the 2012 European sovereign debt crisis, the European Central Bank (ECB) has proven and diversified tools at its disposal; the period of negative interest rates is over and European yields are now at attractive levels relative to history; and the ECB is no longer constraining the supply of euro bonds through quantitative easing.

The depth and liquidity of the euro bond markets have also been issues in the past but have improved over time. In investment-grade corporate credit, for instance, the euro market is now over 40% the size of the USD market—plenty big enough to warrant a higher allocation for global investors.

A modest percentage reallocation out of USD bonds into euro fixed-income could have an outsize impact in price terms, in our analysis. For example, the German government bond (Bund) market is one-tenth the size of US Treasuries, so every dollar that moves out of Treasuries has a proportionately higher market impact on Bunds.

Interest Rates in Europe Have Further to Fall

We believe that interest rates in the euro area have a more clearly defined path to fall than in the US, with potentially less volatility. In the short term, US tariffs and policy uncertainty will continue to weigh on European economies. Meanwhile further disinflationary forces may come from China, whose exports will likely be partially redirected to European markets. These pressures could lead to inflation undershooting the ECB’s targets, paving the way for more rate reductions than the single cut in our current forecast.

Meanwhile, medium-term growth prospects for the region have improved, thanks to large-scale fiscal easing by Germany, Europe’s largest economy. In our view, this would likely be supportive of credit.

European Corporate Credit Looks Attractive

Although the US’s recently-agreed baseline 15% tariffs are higher than the ECB’s base case, we believe they won’t cause major disruption to credit markets, and European high-yield and investment-grade bonds still look compelling to us. European corporates entered the economic slowdown with strong balance sheets and healthy margins and could continue to weather further economic weakness, in our view.

European credit markets also enjoy strong technical support, with buyers emerging whenever spreads and yields increase. As cash rates in Europe progressively dwindle, we expect further flows out of deposit and money market funds to continue to support European credit markets.

European Rates and Credit Are Negatively Correlated

While US rates and credit markets have seen periodic shifts in correlations, in Europe these two asset classes have remained negatively correlated throughout (Display).

In Europe, Negative Correlation Between Rates and Credit Remains Intact

Euro High Yield Spreads (OAS) vs. 10-Year German Bunds Yield

Two lines—showing euro high-yield spreads and 10-year German Bund yields—have moved in opposite directions since May 2024.

Past performance does not guarantee future results.
Euro High Yield is represented by Bloomberg Euro High Yield Index.
As of July 31, 2025
Source: Bloomberg and AB

We believe this supports the case for a European credit barbell—a strategy that combines rates and credit exposure in a single, dynamically managed portfolio. A barbell approach seeks to balance the two main risks within fixed-income markets: interest-rate risk and credit risk.

In a barbell portfolio, higher-quality assets such as government bonds help mitigate drawdowns in times of market stress—such as during the present period of trade-policy volatility—while higher-yielding assets such as high-yield corporate bonds provide extra yield and return when markets are doing well. The respective allocations are managed dynamically.

European Assets Have Potential to Improve Risk-Adjusted Returns

For US and other US dollar-based investors, an allocation to a European core plus strategy has the potential to diversify sources of income, differentiate yield contribution and improve risk-adjusted returns, in our view.

While US policy changes have whipped up storm-clouds worldwide, we see a potential silver lining for alert investors: prudent, proportionate and timely diversification could prove to be their trump card.