Investors seeking that extra boost in corporate bond yields might find Europe to be a more promising destination than the U.S., as suggested by BlackRock. In its 2025 outlook, the BlackRock Investment Institute emphasizes the importance of being selective in fixed income. While Europe has historically lagged behind the U.S. in economic growth, the bond market there appears to be in a favorable state.

Unlock Higher Yields with European Corporate Bonds

Selectivity in Fixed Income

According to Amanda Lynam, head of macro credit research at BlackRock, experts are inclined to be selective in fixed income overall. Despite Europe's economic growth lag, European credit seems to be performing well. High yield within European credit has outperformed investment grade, indicating that the market within Europe is not overly burdened by significant growth risks.This selectivity is also reflected in valuation. Wei Li, BlackRock global chief investment strategist, points out that European high yield is trading roughly 100 basis points cheaper than that of the U.S., which was an average of 15 bps cheaper in the five years prior to the pandemic. Additionally, investment grade debt in Europe is also trading at a discount.

Structural Tailwinds in the European Debt Market

Lynam highlights some "structural tailwinds" in the European debt market. It is smaller compared to its U.S. counterpart, and the European Central Bank still holds a portion of corporate credit from previous bond-buying episodes. Moreover, there are U.S. firms that sell debt overseas, reducing Europe's pure exposure to its own prospects. These factors contribute to the market's resilience despite some growth weaknesses.However, an increase in global tariffs could introduce complexity to the global economic growth story.

Playing the European Debt Market

For U.S. investors, getting exposure to European debt can be a bit challenging as there are no major exchange-traded funds focused explicitly on this sector. But there are some funds on the market with a significant concentration in Europe. For instance, the SPDR Bloomberg International Corporate Bond ETF (IBND) and Invesco International Corporate Bond ETF (PICB) have over 70% of their exposure in Europe, including the U.K. The iShares International High Yield Bond ETF (HYXU) has more than 80% of its exposure in Europe, with around $50 million in assets. This year, HYXU has performed the best, with a total return of about 2% and a 30-day SEC yield of 4.90%.It's important to note that yields from foreign debt can be influenced by currency markets. Investors can also explore active funds where managers share BlackRock's perspective and are increasing exposure to European debt.

After an exceptionally active hurricane season, catastrophe bonds have emerged as a lucrative investment option. These bonds, which transfer risks associated with extreme natural disasters to the capital markets, have shown remarkable resilience despite the increase in extreme weather events. In 2024, they are on track to deliver about 16% returns, following a record 20% in 2023.

Key Reasons for Returns

The senior fund manager at Plenum Investments AG, Dirk Schmelzer, attributes the slightly lower returns in 2024 to the decline in Treasury rates and the rise in investor demand. This has allowed issuers to price their bonds at better terms, putting a little pressure on cat-bond spreads. Yields have slipped from almost 14% at the end of May to about 10.3% at the end of November.Plenum estimates that the volume of catastrophe bonds in funds marketed under Europe’s UCITs label has risen roughly 49% since the end of 2022 to $13 billion at the end of September. Overall issuance for 2024 is set to hit a record $16.5 billion.

Performance of Plenum Funds

Plenum’s defensive UCITS cat-bond fund, with about $400 million of assets, generated a 12% return so far in 2024. Its dynamic fund, with about $210 million of assets, gained about 15%. These figures highlight the potential of catastrophe bonds in different investment strategies.Over the past two years, the average expected loss rate for cat bond holders has dropped to as low as 2% from an average 2.5% during the previous three years. This indicates that it now takes a bigger catastrophe to significantly dent returns. The increase in the attachment point, which is the threshold at which a bond triggers and investor capital starts covering insured claims, reflects this trend.

Impact of Climate Change

This year is set to be the hottest on record, with the average global temperature soaring to 1.62°C above pre-industrial levels in November. Swiss Re AG estimates that insured losses from natural catastrophes will likely exceed $135 billion in 2024, marking the fifth consecutive year of crossing the $100 billion threshold.Much of this increasing loss burden results from value concentration in urban areas, economic growth, and increasing rebuilding costs. Climate change is also playing an increasing role by favoring the conditions leading to many of this year’s catastrophes. Higher temperatures are supercharging secondary perils such as wildfires and severe convective storms. SCSs alone are expected to add more than $50 billion to insured losses this year.

Market Response to Hurricanes

Investors in catastrophe bonds weren’t called on to cover any losses caused by Hurricane Beryl, and a lot of the impact of Helene and Milton was flood-related. This meant cat-bond investors were largely unaffected. Twelve Capital AG, a Zurich-based cat-bond investor, noted that while there were a number of strong hurricanes that made landfall, as they didn’t directly hit major metropolitan areas, the impact on the reinsurance and cat-bond markets is likely to be muted.Jeff Davis, partner and portfolio manager at Elementum Advisors, which manages about $4 billion of insurance-linked securities, believes 2024 is “setting up to be the second-best year in the market’s history” for cat bond investors. And “now that spreads have come down, sponsors are buying more coverage.”

Avoiding Secondary Perils

Specialist cat-bond fund managers are seeking to avoid exposure to secondary perils. These are aggregate rather than single-event shocks like a hurricane and are proving much harder to model. For insurers, perils such as thunderstorms, wildfires, and floods now pose the biggest risk.“We are seeing a bit more of a shift to aggregate transactions,” said Elementum’s Davis. But there’s “not enough comfort” about how secondary perils are modeled for investors to want such exposure. Plenum’s Schmelzer also said he’s aware of efforts by issuers to add secondary perils to the catastrophe-bond market but “we tend to underweight them.”