Britain’s decision to start its divorce from the EU and France’s looming presidential election are injecting political risk back into markets. Bond investors are braced for political volatility. But are they ready for big monetary policy changes?

After Brexit, Frexit?

Investors have hardly been caught unawares by the UK government’s decision to trigger Article 50 formally and start the process of leaving the European Union (EU). The government has been saying for months this would happen by the end of March. Now that Brexit has begun, a tense two years of negotiations between the UK and the EU will follow. Stumbling blocks are almost certain—and could unsettle markets along the way.

A more immediate concern is France’s looming presidential election. Far-right National Front candidate Marine Le Pen, who has pledged to take France out of the single euro currency, is among the frontrunners. Le Pen is almost certain to get through the first round of voting on April 23. But she’s widely expected to be beaten in the second-round run-off on May 7.

Even if Le Pen is elected, it’s far from certain that she’d be able to push through France’s exit from the EU—referred to as Frexit. But a Le Pen presidency would certainly lead investors to start pricing in a higher probability of a euro-area breakup. They’re understandably nervous as the elections approach.

Bond yield spreads reflect this anxiety. The spread between French and German government bonds has widened significantly—and could widen further through at least May 7. If Le Pen is defeated, spreads will probably snap back. But if she wins, they could widen to levels not seen since the worst of the euro-area crisis five years ago. France’s sovereign debt would bear the brunt of political uncertainties, but the rest of the euro area probably wouldn’t escape unscathed. Peripheral bond yields could be driven higher and 10-year Bund yields lower, while the euro exchange rate would likely weaken.

The European Central Bank (ECB) would act swiftly to try to avert sustained market turbulence—most likely by buying up the most beleaguered bonds.

Are Policy Changes Looming?

What’s less certain is how the ECB will respond if Le Pen is beaten and Europe swerves its biggest potential political upset this year. Bond markets could be in for a nasty surprise. They’re expecting the ECB to begin scaling back its quantitative easing (QE) program from late 2017 or early 2018. But a more stable political outlook, together with better-than-expected European growth rates, would increase the chances of the ECB starting to taper early—perhaps in the second half of this year.

The ECB is acutely aware of the need to tread lightly: it will seek to ensure that any removal of support for Europe’s bond markets is both well signposted and gradual in a bid to contain any resulting bouts of volatility.

That said, bond markets will need to make big adjustments as a world without QE nears. Looking at the relationship between US Treasuries and Bunds before the ECB began QE, Bund yields should be significantly higher than currently—we estimate as much as 1% higher. So sharp swings in bond prices could be looming.

Against this complex backdrop, what are the priorities for European bond investors?

Look Beyond Europe. Seek exposure to bonds that could deliver valuable diversification from potentially volatile euro-denominated assets. A more global approach could help European investors shelter from Europe’s political risks, while also benefiting from differing dynamics in emerging and developed markets. Emerging-market bonds could rally as inflation falls and local interest rates decline, just as developed-world bond yields come under pressure from stronger inflation and rising rates.

Consider Securitized US Assets. 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. CRT’s 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.

Increase Issuer Diversification. Investors should pursue greater diversification across bond issuers in the corporate universe. Often, European corporate issues denominated in another currency offer a wider credit spread than in their domestic market.

In these complicated times, investors must be proactive about their bond-market exposure. By ensuring that fixed-income portfolios are well diversified, and astutely positioned, we think it’s possible to gain a greater degree of comfort to ride through bumps ahead on both the political and the policy front.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.

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