As the UK government looks pulls the trigger on Article 50, John Taylor, Manager of the Diversified Yield Plus Portfolio at AllianceBernstein, says investors should be more concerned about the possibility of exit plans on the other side of the Channel.
The Brexit trigger has been so well signposted that it is likely to have only limited initial impact, although investors should watch developments in Scotland, even if another independence referendum would be a drawn-out process.
With the French presidential election looming, a more pressing concern is ‘Frexit’, a process which would result in France leaving the European Union (EU). Marine Le Pen, the Front National candidate, is polling well in the run-up to April’s presidential election and looks likely to win the first round. She has pledged to lead France out of the single currency. However, even a Le Pen win would not make Frexit a foregone conclusion, as the Front National is unlikely to win sufficient National Assembly seats to enact her policies and such a decision would probably be subject to a referendum.
However a win by Macron or Fillon might also not lead to plain sailing with the European Central Bank (ECB) indicating its willingness to start scaling back its quantitative-easing (QE) programme from late 2017 or early 2018. As European growth and inflation figures are broadly improving, the economic fundamentals would support such a decision. If we look at the relationship between US Treasuries and German bunds before the ECB initiated QE, we can see that bund yields would be about 100 basis points higher without QE. So when QE does end, we could be in for a shock and therefore would expect the ECB to tread lightly.
What should the priorities for bond investors be?
With political risk clearly back on the table investors should look to globalise their euro-denominated assets. A global approach offers not only shelter from Europe’s political risks, but also the benefits of asynchronous cycles of inflation in developed and emerging markets. These could see emerging-market bond yields fall even as yields rise in the developed world.
Another good source of diversification and income comes from US securitized assets. Credit-risk-transfer securities (CRTs) from the US government housing agencies Fannie Mae and Freddie Mac allow investors to tap into a strong US housing market. Their floating rates make them especially appealing as US interest rates rise. Unlike typical agency debt, CRTs do entail credit risk. But their high yields provide handsome compensation – and these investments are generally in the early stages of their credit cycle.
Investors should also ensure that they benefit from increased issuer diversification in the corporate universe. Often, European corporate issues denominated in another currency offer a wider credit spread than in their domestic market. By thus ensuring that their fixed-income portfolios are globally diversified and astutely positioned, investors can prepare to ride the bumps in the political road – either Brexit or Frexit – with some degree of comfort.
John Taylor – manager, Diversified Yield Plus Portfolio – AllianceBernstein