M&G Lured by Europe’s Growth Story Seeks to Avoid Political Risk

  • Need to balance economic boon with lingering threats, M&G says
  • Fund is hedging Italian bond buying with credit default swaps

Europe’s largest economies present bond investors with some of the region’s biggest opportunities next year. They also contain one of its main risks: politics.

That contrast presents money managers with their key challenge in 2018 -- how to capitalize from the improving euro-area economy while protecting their investments from risk events such as the Italian election, according to M&G Investments, one of the continent’s largest funds overseeing about 280 billion pounds ($376 billion). While the company is still buying Italian debt, it is hedging the risk of a political upset through credit default swaps, M&G money manager Wolfgang Bauer said.

“There’s a bit of a dichotomy in Europe between economic strength on the one hand and political uncertainty on the other,” Bauer said. “The key challenge for 2018 is to position our fund in a way to on the one hand benefit from the benign economic environment, while on the other hand protect the portfolios from potential political risk events.”

Even as 2017’s portfolio threats such as the rise of far-right parties in France and the Netherlands failed to materialize, the recent independence push in Spain’s Catalonia and Italian elections penciled for March highlight that it’s too soon for funds to rest easy. Political uncertainty could still derail the economic recovery that has taken root this year, according to Bauer. Alongside Italy, Germany’s continuing struggles to form a coalition government and doubts over the reforms of French President Emmanuel Macron are also concerns.

The yield on Italy’s 10-year debt has risen about 15 basis points to 1.79 percent in the past week amid reports that voters will head to the ballot boxes on March 4. The euro-skeptic Five Star Movement, which is leading in some recent polls, could upset the established political order and pose a challenge to greater euro-area integration. ING Groep NV sees the yield premium of 10-year Italian bonds over Germany climbing to as much as 200 basis points into the vote from around 150 basis points currently.

Still, with investment-grade Italian bank debt yielding less, government bonds still provide an attractive source of returns and liquidity for M&G. The Absolute Return Bond fund, which returned 2.7 percent this year, is still buying the nation’s debt securities because the valuations compared to those of corporates are more favorable, Bauer said.

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