The interest rate spread between European and American central banks is large. Fund managers are betting that European corporate bonds will outperform.

In the $13 trillion high-grade corporate bond market, investors are closely watching an unprecedented divergence between the monetary policy paths of the United States and Europe. Some fund managers believe that the returns on European corporate bonds may outperform their U.S. counterparts, as the European Central Bank is expected to cut interest rates multiple times this year, while the Federal Reserve is expected to maintain higher rates for a longer period. Mark Benstead, senior portfolio manager at Legal & General Investment Management, said, "If current interest rate expectations stay the same, you can expect better total returns on euro bonds. It can be said that the euro also has more protective measures." He added that because the spread on the euro market is not as close to historical lows as the dollar or pound. The current divergence at the beginning of this year is unprecedented. The only other significant divergence in interest rate expectations at the beginning of the year occurred in 2023, when traders expected rate hikes instead of cuts. When interest rate expectations diverge, investors have almost no options to increase returns. Investors make money through corporate bond coupon income and price appreciation, which is achieved when spreads narrow or comparable government bond yields drop, as this would push down overall corporate yields and boost prices. However, after a period of significant inflows, the spreads for this asset class have become very tight, reducing opportunities to profit from betting on lower-risk premiums. Borrowers have flocked into the global bond market at an unprecedented pace, targeting cash-rich portfolio managers. Since last summer, funds have been flowing in continuously, giving these portfolio managers cash to spend. On Tuesday, the EU received over 170 billion euros ($174 billion) worth of orders for two batches of bonds, while Greece attracted over 31 billion euros in issuance, marking overall demand for new bonds. Interest rate traders expect the European Central Bank to cut rates by more than three times 25 basis points by the end of 2025. In contrast, after last Friday's employment data showed a booming U.S. labor market, the market almost believes that the Federal Reserve will not cut rates this year. European Central Bank policy makers have indicated that the Eurozone's monetary policy will take precedence. ECB Governing Council member Olli Rehn said on Monday that regardless of what the Federal Reserve does, the ECB should continue to cut rates. He joked that the ECB is not the 13th Federal Reserve district. Certainly, as new economic data is released, market expectations for rate cuts by the European and American central banks may change rapidly. For example, in early December, traders expected the Fed to cut rates by more than three times in 2025. Since then, Fed Chairman Powell has remained cautious after the last rate meeting in 2024. Last week's better-than-expected data indicates the Fed has almost no reason to further cut rates. In contrast, the Eurozone economy is struggling, and inflation is expected to fall back to the 2% target in 2025, which means that rising prices are a secondary issue for ECB policy makers. With spreads, particularly in the United States, approaching record lows, the potential for generating returns from corporate bonds through this avenue is limited. This makes the performance of underlying government bonds a key factor in asset class performance this year. Andrea Seminara, CEO of Redhedge Asset Management, said, "The credit spread part is irrelevant, everything is about the benchmark interest rate. If central banks surprise with rate cuts, it will affect European credit in terms of the rate component. Everything will be driven by interest rates."