European credit: political shocks, rate cuts, and a flight to quality

How we’re walking the tightrope by balancing caution and opportunity

By Marc Rovers, Head of European Credit and Magdi Yasin, Fixed Income Specialist

The past – what just happened?

European credit markets have experienced volatility in recent months, shaped by a mix of political, monetary, and geopolitical developments. At the same time yields have proven to be remarkably stable moving between 3 and 3.2% as moves in government bond yields were partly offset by opposite moves in credit spreads.

In August, political uncertainty in France – centred around Prime Minister François Bayrou’s likely loss of a confidence vote – triggered a sharp rise in French sovereign risk, with spreads between French and German 10-year bonds widening up to 15 basis points and French yields approaching Italian levels. This instability weighed on French corporate issuers, leading to some underperformance, though to a much lesser extent than that of French sovereign, and a widening of euro investment grade credit spreads. European markets also continue to be influenced by Germany’s historic reform of its constitutional debt brake, enabling substantial new infrastructure and defence spending and triggering a sharp repricing in rates.

The European Central Bank (ECB) has lowered interest rates twice in March and June by a quarter basis point each time, before signalling a prolonged pause in policy changes in July, prompting a drop in Euro government bond yields. In contrast, the Bank of England cut rates by one quarter basis points in response to persistent inflation, but its hawkish tone pushed gilt yields higher and supported sterling.

Throughout the third quarter of 2025, European credit delivered robust total returns, driven by strong investor demand and a tightening of spreads to multi-year lows amid a favourable backdrop.

The present – value amid volatility

We are prioritising higher-rated issuers over BBBs and keeping portfolio beta near neutral (~1.0) and duration flat (in line with its benchmark) to avoid adding undue risk at what are historically tight valuations. Key macro drivers have reinforced a more cautious approach: euro credit spreads hit the 10th percentile of historical levels by mid-August, even as the ECB signalled policy pauses. With yields relatively stable, credit markets have been supported by strong technicals, but we expect volatility to pick up as heavy new issuance returns in September. In this context, we maintain a more cautious bias, favouring high-quality credit, more defensive sectors, and a well-diversified approach that avoids over-extension on risk.

We are significantly underweight French credit as French corporate spreads were too small. As political uncertainty has risen, this led to French corporates somewhat underperforming but not enough to warrant a change in this position we believe especially when looking at French banks. Conversely, we see pockets of value in defensive sectors: notably, we hold an overweight in UK utilities, especially water companies, which we believe offer attractive spreads after regulatory pressure drove them cheaper than the market.

We’re also currently leaning more towards financials (banks) and select infrastructure and utility names where fundamentals are robust and new issues provided entry points. European banks are benefiting from higher rates and solid balance sheets, and their debt still offers reasonable spread pickup; we remain underweight economically sensitive industrials as we are concerned about growth and a potentially delayed impact of the US tariffs.

Outlook

European investment grade (IG) credit markets enter the fourth quarter with a cautious outlook amid lingering macroeconomic and political uncertainties. The ECB is expected to hold rates steady after earlier modest cuts, but fiscal shifts (like Germany’s expanded public investment) and political risks (such as recent turmoil in France’s government) could still add volatility. The tariffs imposed by the US administration also add another layer of uncertainty, potentially impacting US inflation and corporate margins, with global trade flows still very much unclear.

Credit spreads hover near multi-year tight levels after a summer rally, leaving valuations rich and little room for error. Even as bond issuance picks up from the summer lull, strong demand and steady inflows should support the market. New deals have been largely absorbed without major concessions, yet elevated hedging activity and neutral broker positioning reflects investors’ wariness heading towards the end of the year.

What could go wrong?

• Valuations are stretched, with euro IG spreads near historical tights, leaving little room for error.
• Political instability in France could escalate, further widening spreads and dragging down French corporate performance.
• The impact of US tariffs become clearer in the macro data leading to concerns about US inflation and global growth.
• Recession risks in the eurozone could rise with the US tariffs and Chinese competition, weakening corporate fundamentals and increasing downgrade pressure.

• Rising geopolitical tensions and a further expansion of the war in Ukraine into countries bordering the conflict area.
• Investor sentiment remains fragile, and any reversal in fund flows could amplify spread widening with no ECB backstop through the corporate sector purchase programme.
• Cross-currency volatility and rising FX hedging costs may reduce global demand for euro credit.

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Source of all data: L&G as at 30 September 2025.

_{Important Information: For professional clients only. Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Views expressed are of L&G as at 30 September 2025. The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272}