Why have EUR credit spreads been higher than USD credit spreads since 2022?

The USD and EUR IG indices are the largest and most widely followed indices in the corporate bond sector. Accordingly, investors pay close attention to the spread levels of these indices. The chart below shows the evolution of the index spreads of both indices since 2001.

As can be seen, EUR IG spreads have been lower than their USD IG counterparts for most of the century. This also makes sense, as USD indices have a higher duration and therefore a higher risk than EUR IG indices. The only exceptions were the euro debt crisis of 2010 – 2012 and the last two years, when EUR IG spreads were significantly higher than those in USD. During this period, there was daily talk of sovereign defaults, the reintroduction of national currencies and the end of the euro. A risk premium in Europe seemed plausible. The question is why EUR IG bond spreads have been so much higher than USD bond spreads over the past two years.

The spread difference between the two indices for the last ten years is shown in Figure 2.

While the spread differential was at or below zero for most of the time, a new regime with a spread premium of 20 to 40 basis points for EUR IG corporate bonds is seen from February 2022.

We want to answer the question of what is driving this increase in relative spreads and what are the prospects for EUR IG bonds to outperform USD bonds when the spread differential returns to its original level.

Initial hypothesis: Structural differences in the indices

The two indices are not identical in terms of maturity, rating and sector. For example, the USD IG index traditionally has a significantly higher proportion of long-dated bonds, while the EUR IG index has a significantly higher proportion of financials over time. We analyse whether differences in the composition of the indices are responsible for the divergence.

We calculate the spread per maturity band (0-3 years, 3-7 years, 7-13 years, 13+ years), rating class (AAA, AA+, AA, AA-, … BBB-) and sector at the end of each month for the USD index. We use the weights of the US index and the weights of the EUR index and multiply them by the US spreads as a weighted average of the spreads of the different dimensions (maturities, ratings and sectors). In this way we obtain a synthetic USD-IG index spread, once for the USD and once for the EUR index composition. The difference between the two indices is our measure of the structural differences between the indices.

In addition to the EUR and USD IG indices, Figure 3 shows the synthetic USD IG index, which has the same maturity, rating and sector structure as the EUR IG index.

The chart zooms in on the last ten-plus years of the two indices and the synthetic index. The level of the synthetic USD IG index spread is lower than that of the actual USD IG index. This suggests that the USD IG index is riskier than the EUR IG index and should therefore have a higher spread than the EUR IG index. A USD IG index with the same structure as the EUR IG index would have even lower spreads. For March 2024, this structural reduction effect is -8 bps, most of which comes from the longer maturity structure (-9 bps). Rating differences (-1 bps) and sector distribution (+2 bps) contribute insignificantly to the differences.

Figure 4 shows the composition of the spread effect resulting from the structural differences between the EUR IG and USD IG indices over time, broken down by maturity, rating and sector contributions.

In the time series of the structural differences, the longer maturity structure of the USD IG contributes to a higher spread. If the maturity structure of the USD index had been aligned with that of the EUR index, the spread level of the USD index would have been ten to twenty points lower over the last few years.

Figure 5 shows that structural differences between the two indices are not the reason for the current spread premium of the EUR IG credit index. Rather, the USD IG index would have an even lower spread level if it had an identical structure to the EUR IG index and therefore the spread premium of the EUR IG credit index would be even higher. This difference has increased significantly since Q1 2022 and remains at a high level.

Further hypotheses on spread differences

Since a different sector, maturity and rating structure cannot explain the spread differences, we analyse other hypotheses that could explain them by means of a multivariate regression. The hypotheses and the operationalisation for the regression are as follows:

• Different growth in the USA and the eurozone: Higher growth in the USA can be the reason for lower credit spreads in the USA, as higher growth is accompanied by lower default rates in the market. We operationalise this effect with the difference in annual GDP growth rates between the US and Germany, the largest economy in the eurozone.¹
• Currency changes: Changes in the EURUSD exchange rate have an impact on import and export-orientated companies in the USA and Europe and can have a systematic effect overall. We operationalise this effect with the EURUSD exchange rate.
• Different interest rate paths in Europe and the USA: Differences in the interest rate path reflect differences in growth potential, the position in the economic cycle and the inflation rate. These differences affect the profit potential of companies and thus their probability of default. We operationalise this effect with the monetary policy rate differential between the USA and Germany.²
• Geopolitical risk: Whether it is the euro debt crisis or Europe’s energy security since the loss of Russian gas in 2022, Europe has to cope with geopolitical risks that do not affect the USA. This puts European companies at a disadvantage and could justify higher spreads for European companies. We operationalise this effect with the German sovereign CDS spread.
• Additional central bank demand: The ECB bought corporate bonds on the market over long periods of time, first from June 2016 to December 2019, then from the Covid crisis until 2023. While the Fed also intervened in the market in the short term around Covid, it was primarily the ECB that provided the additional demand. We operationalise this effect with a dummy that is one in months in which the ECB bought corporate bonds and zero otherwise.
• Additional supply: The supply of bonds on the market is driven by (net) new issues. If supply increases while demand remains the same, spreads should rise to balance the market. If there are systematic differences between USD and EUR bonds, this can lead to spread differences. We operationalise this effect with the ratio of the growth rate of the volume of the Bloomberg EUR IG Index and that of the Bloomberg USD IG Index.

We analyse the relationships in a multivariate regression using monthly data for the period January 2013 to March 2024 by regressing the above variables on the difference between the EUR and USD IG credit indices, corrected for structural differences. We try to explain why the spread premium of the EUR index is higher than justified by structural differences. Table 1 shows the results of the regression analysis:

The regression results show that three variables have a highly significant coefficient: A higher growth rate in the US compared to Germany, a higher interest rate differential between the US and Europe and a higher German CDS spread lead to a higher spread differential between the index spreads adjusted for structural differences. The other variables are insignificant or marginally significant.

Among the key variables, the German CDS spread explains 19 basis points of the average difference, while the growth differential between the US and Germany can explain 8 basis points. The spread difference can therefore be interpreted as a mixture of diverging macro trends and geopolitical risk premia. ³

Summary

Looking at the chart in Figure 1, we can see that something has changed in 2022 that has pushed EUR IG credit spreads well above the level of USD IG spreads. This move cannot be explained by structural differences in the indices. Our analysis shows that European geopolitical risk and the growth differential between the US and Europe are the most important components in explaining this spread differential. Although both indices are composed of global issuers, the proportion of European companies in the EUR IG credit market is significantly higher than in the USD IG index. As the market does not expect harmonisation of these variables in the near future, the spread differential (adjusted for structural differences) is likely to persist for some time. The higher spreads in the EUR IG credit segment therefore also reflect higher risks.