Nordic Fixed Income - Corona (Covid19) update interview
23.04.20
Insights

Second interview with our Nordic Fixed Income managers – Corona (Covid19) crisis impacts

Dag A.D. Messelt, CEFA

Nordic Fixed Income Update - Is the bond market crisis over? I have discussed with our Nordic portfolio managers. Q – What is on the top of your mind now after the liquidity crisis we have seen in the Fixed Income credit markets? We are asking ourselves many questions now:

• What is different and a particularity in the Nordic credit markets now? Opportunities?
• Where could you hide in the crisis? Looking backwards
• How could a health crisis become a financial crisis?
• What did we learn? Looking forward to improve.
• Next up now is the Q1 earnings season, now we will see the real impact on company P&L accounts.

Nordic Fixed Income Manager

Morten Steinsland

Head of Fixed Income
Portfolio Manager IG

Nordic Fixed Income Manager

Torolv Herstad

Portfolio Manager IG

Nordic Fixed Income Manager

Tom Hestnes

Portfolio Manager HY

Nordic Fixed Income Manager

Henrik Høyerholt

Credit analyst HY

Q –Did any Nordic Fixed Income market stick out in this crisis or were all markets behaving the same?

Norway is different as it was a “high interest level” country and has exposure to oil related activities.

1)
Looking at for instance Norwegian IG (Investment Grade) bank spreads, we saw a before unseen spread widening in a very short time, multiplying spreads by four, from 50 to over 200 basis points (bps). Then we saw a quick contraction, almost halving the spread again. All in a couple of weeks each way. In 2008 it took 4 months or more both ways. These movements say a lot about the market dynamics or maybe lack of dynamics. In Sweden and Europe, we saw the same type of credit spread widening, but in Sweden we have not seen the same force in widening and tightening as seen in Norway. This drastic tightening may be due to the financial strength of the Norwegian banks and the Norwegian State Bond Fund reopening.

We have also seen that for Cocos, the NOK (Norwegian krone) spreads have tightened more than in the EUR (euro) and SEK (Swedish krona) market after the initial spread widening.

FIGURE 1 – IG spread evolution (basis points) – Nordic selection (NOK and SEK), EUR and USD markets

2020 04 Insight - Nordic Fixed Income - Corona - Figure 1

Source: Alfred Berg, Nordic Bond Pricing, Bloomberg per 16/4/2020

FIGURE 2 – IG spread evolution (basis points) – NOK selection, SEK selection and EUR markets

2020 04 Insight - Nordic Fixed Income - Corona - Figure 2

Source: Alfred Berg, Nordic Bond Pricing, Bloomberg per 16/4/2020. Historic performance is not an indicator for future performance.

2)
Another particularity is the difference in “risk free” long term yields between Norway and other markets like Europe and Sweden.
The places where we have seen “risk free” long term yields fall is really only in markets where the yield levels were higher, like the USA and Norway. They collapsed, while the economies with “risk free” long term yields already close to zero did not move much. In Sweden, they actually increased in March. 5Y “risk free” yield difference between NOK and EUR came from 170 bps and moved to under 100 bps.

Q -What implications did this have for Nordic Fixed Income and did we learn anything from this?

As a result of the two points above, there is no surprise that funds in different countries and currencies performed very differently in such an environment.
Long duration NOK IG credit funds have seen a relative positive contribution from stark fall in relative long term “risk free” yield levels and at the same time they have benefitted relatively from the quicker tightening in IG spreads. They outperformed EUR IG credit funds.

Historically in financial market crisis, investors could hide in government bonds, as you expect the “risk free” long term yields to fall. This time the “risk free” long term yields did not fall much for most currencies, so this strategy did not work in EUR and SEK. In NOK it worked. NOK IG credit long duration performed even better then EUR government bonds since the beginning of 2020.

Lesson learned:
The long duration hedge against economic crisis does only work when there is a yield level that actually can fall and that close to zero yield levels does not fall in the same amplitude.

Q -Are there any other things we have learned in this Nordic Fixed Income market crisis?

1)
When bond valuation in a market is mainly based on screen pricing, we saw the priced lagged so much in this crisis that many fund managers had to close their funds. The argument was that they were not in a position to set a correct NAV. We saw this to a large extent in Sweden. In Norway, we rely on Nordic Bond Pricing, an external price source, and this was a good thing in this crisis. Almost no Fixed Income funds closed for redemptions in Norway.
Should Sweden change from a screen priced bond market to a Nordic Bond Pricing model, i.e. a centralised pricing agency that can price bonds realistically in a difficult market, based on market spreads rather than on executed prices? We think this would be a good idea.

2)
Another mechanism that is important for Fixed Income managers are anti-dilution levy (ADL) mechanisms or swing pricing. When the market is suffering from liquidity, we cannot accept that remaining fund shareholders take the bill for the shareholders selling their shares. Swing pricing is a NAV adjustment that takes into account the market impact of a shareholder that selling their shares and ensures that the selling shareholder pay for this. The payment through a lower NAV is benefitting the fund, hence the remaining shareholders. Swing pricing is forbidden in Sweden and not practiced widely although it is legal in Europe. This is something that should be considered to implement. This is particularly important due to the changes after 2008 where banks no longer function as a liquidity provider in the FI market.

3)
On the latter point, the solutions to the 2008 crisis has clearly led to the current health crisis becoming a financial market crisis. This is a paradox, what seemed to be good banking regulation after 2008, in reality removed a liquidity source. And we really felt this in the current crisis. This must be addressed, and it has partially as the global central banks have stepped in to offer this liquidity. But to really work, it has to be permanently in place. Not a week after the market crashed. Another problem is that the liquidity they offer does not find its way to the whole market, or only addresses segments of it. Asset managers should be able to access the Repo market directly with the central bank in Norway and likewise in other countries.

4)
How to deal with the weaknesses of the market structure already now? After this liquidity crisis, many fund managers are considering increasing the liquidity buffers in their funds. For instance a minimum allocation to Mortgage Covered Bonds? This would lead to lower expected returns for credit funds.

5)
Hedging impacts on liquidity
NOK weakness created an extra tough liquidity crisis in the Norwegian market, as funds hedged to NOK had a surge in margin and collateral calls due to the drastic NOK weakening. This forced some funds to sell bonds at undervalued prices.

Lesson learned:
There will be many discussions in the Fixed Income space after this crisis, we do not dispose of all the tools we need as a fixed income fund manager in all the European markets and liquidity buffers will likely increase in all funds.

Q – Has the Nordic Fixed Income spreads come in too much short term?

The Nordic IG spreads were too high at the top relative to fundamentals. However, is there is an incoming real economy crisis; there will be defaults and credit losses. If this is already priced today depends on how long this will last. The Q1 earnings season that has started will give more clarity on the impact on companies. This is probably the most important guide for the market now.

Q -Duration exposure to the right yield curve (NOK Fixed Income) has been very good, is it now too late to play this?

We do not have a clue for the next weeks, the visibility is too low. Is it more likely that the long term “risk free” yields fall then that they rise? If you think so, you should still be long the NOK long duration bonds. There is technically still room for falling long term yields as it is not yet at 0% as elsewhere. However, if you think against consensus that the massive money printing in the world will lead to an inflation surge and following rise in long dated yields, you should not.

Q – On the higher risk levels, what is the state of the Nordic High Yield market and how do you see it going forward?

The Nordic high-yield market has seen a swift rebound over the past couple of weeks. Spreads are still elevated, but has seen strong recovery from peak levels. Nordic high-yield indices are up by about 4.5% in April, with strongest gains in Norway compared to Sweden. The Norwegian market was helped by the increase in oil price, up by 23% on production cut agreements and the presence of the Norwegian State Bond Fund.

FIGURE 3 – Norwegian HY spread evolution (basis points)

2020 04 Insight - Nordic Fixed Income - Corona - Figure 3

Source: Alfred Berg, SB1 Markets per 16/4/2020. As there is no Nordic HY index, we use a proxy. Norway is the dominant part of the Nordic HY market. Historic performance is not an indicator for future performance.

Positive news from the US regarding the FED now starting to buy fallen angels, i.e. investment grade companies downgraded to BB high yield over the past month. The Fed’s purchases could have an impact on the Nordic market, but the local liquidity conditions and the oil price outlook as far more important here.

FIGURE 4 – Norwegian HY spread evolution (basis points) compared to international markets

2020 04 Insight - Nordic Fixed Income - Corona - Figure 4

Source: Alfred Berg, SB1 Markets per 16/4/2020. As there is no Nordic HY index, we use a proxy. Norway is the dominant part of the Nordic HY. Historic performance is not an indicator for future performance.

Sweden has experienced high outflow from high-yield funds after many of them closed for redemptions in the worst of the market crisis.
The bond market is vulnerable to new setbacks, although the fiscal and monetary measures to support the economy somewhat mitigates the risk
The global economy is seeing an historic slowdown, which is likely to have a considerable negative impact on corporate debt servicing capacity. Quarterly results will now start coming in, and together with weak macro data we believe this will lead to high volatility going forward.
The Norwegian HY spreads still follow the US HY Energy spreads, despite that energy has fallen from 60% to under 20% of the Norwegian market since 2008. This can partly be explained by a high energy dependency of the Norwegian economy, but there is clearly also a part that cannot be explained.

FIGURE 5 – Norwegian HY spread evolution (basis points) compared to US Energy HY

2020 04 Insight - Nordic Fixed Income - Corona - Figure 5

Source: Alfred Berg, SB1 Markets per 16/4/2020. As there is no Nordic HY index, we use a proxy. Norway is the dominant part of the Nordic HY market. Historic performance is not an indicator for future performance.

Q – How have the Alfred Berg Nordic Fixed Income strategies fared so far this year?

(Data per 17/4/2020. Historic performance is not an indicator for future performance.)

Short bond Strategies
These are the Nordic equivalents to the European Money Market strategies, but with a slightly longer duration. Our Nordic Short Bond NOK hedged strategy is down 0.8% year to date and our NOK Short Bond strategy is down 0.4% year to date.

Investment Grade Strategies
These are all capital preservation strategies where we expect no credit losses. Our Nordic Investment Grade strategy NOK Hedged is down 3.2% year to date. Our Nordic Investment Grade NOK Hedged Long Duration strategy is up 3.4% year to date. This due to the falling market yields. This has worked as a hedge to uncertainty on the economy as the market yields then often are falling. The other funds have performed between these two. The Nordic strategies have performed less good than the Norwegian strategies due to the point mentioned above; SEK spreads have not tightened as much as the NOK spreads after the initial spread widening.

High Yield Strategies
These are more risky strategies, where an investor should expect potential credit losses.
Our Nordic High Yield strategy is down 14.7% year to date and our Nordic Crossover strategy is down 7.6% year to date.

Q – What can we expect now from the Nordic Fixed Income markets?

In the short term, looks good. Longer term it is more uncertain as we do not know the future path of the Corona pandemics and the governments’ actions.

«Risk free» yields are much lower; we are at the sub one percent level.
Credit spreads are much higher. In 2008 we ended at the same spread levels as before the crisis in 4 months.
For most NOK bonds, the total yield is much higher, but it is composed differently. The risk premium required by investors is higher.

Q – What if we see falling Nordic Fixed Income spread levels back to where they were before the crisis as we did after 2008? What are the return levels we then could expect?

This is a very optimistic scenario for the next 12 months, with very rough indications.

NOK Money market equivalent + 2%
NOK IG funds + 5%
NOK hedged Nordic IG + 6%
NOK hedged Nordic Crossover + 11% (corrected for estimated defaults that we should expect)
NOK hedged Nordic HY + 20% (corrected for estimated defaults that we should expect)

Do you have questions about the Nordic Fixed Income markets? Do not hesitate to contact us.

Dag A.D. MESSELT
Investment Specialist
Head of International business Development
ESG Champion

Risk when you invest in fixed income credit
Capital risk: the risk of capital loss because a unit may be sold at a price below that originally paid to buy it. There is no guarantee that unitholders will get back the capital they invested. Should these risks materialize, the net asset value of the UCITS may fall.
Interest rate risk: because of its composition, the Fund is exposed to interest rate risk. Interest rate markets move in the opposite direction to interest rates. If interest rates rise, the Fund’s net asset value will fall. The impact of interest rate movements is measured by the Fund’s “sensitivity” range, which in this case is on a scale of 0 to 5. The sensitivity measures the impact of a 1% change in interest rates on the Fund’s net asset value. A sensitivity of 5 means that a 1% rise in interest rates would be reflected by a 5% fall in the Fund’s net asset value.
Credit risk: the portfolio will be invested in private bonds and other securities issued by private issuers. Credit risk is the risk that the borrower may default. The Fund is consequently exposed to the risk that some issuers may default on the payments they promised to make on the securities they issued. The deterioration in the financial position of an issuer whose securities are held in the portfolio will result in a drop in the net asset value of the Fund.
Risk relating to investments in “high-yield” securities: the Fund must be considered, in part, as speculative and aimed at investors who are aware of the risks inherent in investing in securities whose ratings are low or non-existent. As such, holding high-yield securities entails the risk that net asset value may fall substantially.
Risk relating to over-the-counter transactions on transferable securities: some derivatives markets known as “over-the-counter” markets, in which the Fund proposes to trade, do not offer the same degree of safety as regulated markets that operate on a regular basis, and are recognized and open to the public. Settlement/delivery transactions appear more risky due to there being no clearing house guaranteeing their completion. A default in such settlement/delivery transactions can cause the Fund’s investments to lose value and the portfolio’s net asset value to fall.
Foreign exchange risk (up to 100% of the Fund’s net assets): this is the risk that the exchange rate of the currency in which the financial instruments in the Fund are denominated may weaken, causing the Fund’s net asset value to fall.

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Investments in funds are always related to risk. Past performance is no guarantee of future results. Performances are calculated net of fees. Investments in funds are subject to market fluctuation and risks inherent in investing in securities. The value of investments and the revenue they generate can increase or decrease and it is possible that investors will not recover their initial investment.