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Bond Investors Have Nowhere to Hide from Political Risk

Bond investors beware – all corporate debt is sensitive to political risks and interest rates rising, according to Newton Investment Management

Karen Kwok 16 February, 2017 | 2:34PM

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Bond investors beware – all corporate debt is sensitive to political risks and interest rates rising, according to Newton Investment Management.

“I cannot think of any sector in the European corporate bond universe that is immune from political risks or interest rate risks,” Paul Brain, head of fixed income with Newton told Morningstar this week. Brain believes regardless of the outcomes from each European election, either result would cause an impact on European bonds performance.

If there is no dramatic upset in European politics, the euro-area economy is like to grow, and in turn the European Central Bank will reduce its quantitative easing programme. With fewer bonds being issued, yield would start rising, and values of existing bonds would fall.

“Alternatively if we saw quite significant changes in the political environment, that could be quite disturbing for bond investors,” said Brain, adding that even low-risk sectors such as utilities would be volatile in the event of a political upheaval.

Investors Sell European Bonds

Investors in both active and passive funds have started turning away from European bonds since November, in anticipation of the volatility to come. According to data from Morningstar Direct, UK investors sold funds invested in European corporate bonds in November and December, with £113 million outflows.

Morningstar Direct data also showed outflows of €739 million from European corporate bond exchange traded funds in January – the least popular sector of the month.

Go Short Duration for Best Returns

In December, the European Central Bank extendeed its asset purchase programme to at least the end of the year, albeit at a reduced rate of €60 billion per month from €80 billion per month. Brain believes that the Central Bank will find it very difficult to maintain their asset purchase programme going forward, if the headline inflation rates stays above 2% for a prolonged period. Eurozone inflation in January was at 1.8%, a near four-year high and up from 1.1% in December.

“There is a perception in the market that headline inflation will get down to 1% again. We think it is unlikely,” said Brain.

Facing ever-changing political environment and central bank attitudes, diversification remains to be an important tactic for bond investors, says Brain: “Inflation-linked bonds in Europe still looks cheap. We think government bonds that provide inflation protection will be a good source of income.

“As yields will potentially go up further, I would not buy long-dated bonds now. Short-maturity is better than long-maturity. If you are buying a bond now with two-year maturity, and yields rise, you will get your money back in two-years’ time and you can re-invest that cash into higher yielding bonds.”

Brain also likes bonds issued by banks as he believes bank profits are picking up and lending is increasing. He believes banks can do well in a pro-growth environment however he warned that investors might need to take credit risk.

Investing in Infrastructure and Energy

Brain predicts that President Donald Trump’s ambitious infrastructure spending plan will disappoint, but he does believe there are opportunities of investing in infrastructure bonds globally.

“I think Trump will disappoint on the infrastructure side. The US already holds too much debt, and that does not match with Trump’s spending plans. But I would say more globally we will see infrastructure spending pick up,” said Brain.

“Some European governments will increase infrastructure spending instead of relying on the central bank to stimulate growth. Other European countries do not spend on infrastructure, due to deregulation or lack of labour support, so we will look at each country individually,” said Brain.

Brain admitted that he has been taking profits from infrastructure recently, and was looking to take profits caused by deregulation proposed by President Trump which would help energy companies in the US.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Karen Kwok

Karen Kwok  is a Reporter for Morningstar.co.uk