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Bond investments in favour amid prolonged uncertainty

Glenn Freeman  |  05 Jul 2016Text size  Decrease  Increase  |  

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The current period of global volatility presents retail investors with a number of potentially lucrative opportunities, according to John Likos, Morningstar's head of credit research, Australia.

"There is a lot of risk out there, which will continue to provide support to the safe-haven government bonds," Likos says.

As examples, he names a number of developed countries regarded as having strong economic foundations, including Germany, Switzerland, Netherlands and the UK.

While Likos does not believe the Brexit referendum will trigger a rush to the exits of EU membership by other member states, inactivity on the part of the EU to reform itself and heed the messages of its members could make this possibility very real.

"Our base-case scenario is that the contagion scenario does not play out, instead, we embark on a period of increased uncertainty, volatility and lower benchmark rates for longer," he says.

"In the meantime, higher levels of volatility will present opportunities which could prove rewarding in the long term."

Where to invest now?

In this kind of environment, Likos says investors need to make sure they stick with the stronger, safer exposures and companies.

Looking across the different levels of investor risk profile, he sees lower-risk investors as those who generally use a combination of term deposits and high-grade, quality exposures through products like bonds or blue-chip equities.

"Those higher-risk investors will consider higher-yield bonds, across corporate bonds and also certain hybrids, such as those issued by Crown (ASX: CWN)," he says.

"We like the Australian corporate bond market. Australian bonds are offering a higher yield than most of their developed world peers. I still think the Australian corporate sector is well placed on bonds, with strong credit profiles."

Conversely, global corporate bond markets remain a trickier proposition, at least in the shorter term.

"As long as uncertainty surrounding the implementation of EU withdrawal and contagion risk persists, we expect further spread pressure on global corporate bond markets, especially the UK and Europe," Likos says.

"Higher beta corporate bond exposures could generate strong returns in the near term but we're not convinced for the time being, believing uncertainty surrounding the UK's exit and contagion risk fears will persist near term, driving our preference for high-quality, low-beta exposures."

Current global risk levels

The numerous overlapping threats facing global financial markets highlight the importance of seeking out stable sources of investment income and capital growth.

Pulling out of the European Union is a protracted and unprecedented process--and there is still some uncertainty around whether the UK will exit at all.

Hamish Douglass, CEO of Magellan, suggested in a recent interview that there remains a 25 per cent chance Britain may not leave the European Union.

He also believes the primary risk of Brexit is the potential contagion effect, which could prompt more European countries to leave the trade pact, and possibly even lead to a break-up of the entire EU.

"This combines with a number of other global macro factors that are contributing to slow growth worldwide, including the slow US financial recovery and long-term weakness in oil prices," Douglass says.

On the widespread effect of Brexit, Morningstar also holds this view.

"The key risk for global markets is contagion within the EU. Further departures from the EU could call into question the future of the union," Likos says.

More from Morningstar

Taking advantage of hybrid securities

Know your security when chasing yield

 

Glenn Freeman is Morningstar's senior editor.

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