FUNDMANAGER M. NILSSON OCH F.TAUSON

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Interest rates on short maturities are likely to be low or even negative during the year, and well into 2016. Meanwhile, Catella’s three corporate bond funds have started the year well, and the new Catella Credit Opportunity fund stands out with a gain of nearly 2 percent already this year.

The question is where the hunt for yield will take the market going forward. The flow of capital tends to go from low-yielding government bonds to corporate bonds with investment grade ratings and eventually from there down to the high-yield segment. At least that’s what Catella’s fixed-income managers believe.

The US economy is stronger than Europe, and while we Europeans are struggling to push up inflation the issue in the United States is instead when Fed Chair Janet Yellen will begin to raise interest rates.

The oil price collapse is providing stimulus to parts of the economy, while companies with connections to the sector are clearly suffering.

The economy is in a phase of low interest rates, and the Swedish Riksbank’s most recent cut was to -0.10 percent. The interest rate on a two-year Swedish government bond is -0.14 percent, on a five-year bond 0.20 percent and on a ten-year bond 0.70 percent.

Magnus Nilsson (MN): I would definitely advise against a 20 basis point expected annual return over five years, with the duration risk involved in holding long-maturity bonds. We chose last year to diversify away from government securities, which we believed provided returns that were too low in relation to risk – not least in terms of duration – and we chose the debt route instead.

Does this gigantic package from the ECB, which follows the US stimulus package, suggest that interest rates will remain low for a long time in Europe?

MN: Yes. If there is a big buyer, typical supply and demand mechanisms show that interest rates will remain low for some considerable time. Our best guess is that rates will remain at zero or negative on short-term maturities throughout the year and well into 2016. So for anyone who’s not already done so, it’s high time to mobilise your interest-based savings – from traditional money market funds and from low-interest deposit accounts, and particularly from low-yielding and relatively risky traditional bond funds – into something else.

The US market is further ahead in the business cycle than Europe, and the United States has managed to reduce unemployment. The US market is considering whether, and if so, when, Fed Chair Janet Yellen will change her carefully considered comments about continued low interest rates. Magnus Nilsson anticipates an initial increase in the autumn.

MN: We have no direct exposure to the US market, but the Fed has been quite dovish despite everything. What the market is pricing in is an initial cautious increase in the autumn, but this is likely to be a fairly isolated American phenomenon.

FT: We should remember that it’s very rare for the Fed to scorn the market and come up with downside surprises. Everything has been very well guided all the time, and as long as they continue on that track, there won’t be any shocks.

Some people are speculating that once interest rates start to rise they will rise quite quickly. This is isn’t what you think?

MN: Well, historically things often happen more quickly than you think and with greater magnitude. But it feels more unlikely this time, partly in view of how the Riksbank is acting and partly considering how relatively weak the economic cycle has been. I believe it will be a slower process.

In the autumn, and especially in December, Nordic corporate bonds took quite a beating in the market. Much of what happened was due to the sharp decline in oil prices, which hit the Norwegian oil and oil services sector.

Fredrik Tauson is seeing some improvement of the situation in our neighbouring country now that oil prices have recovered slightly and gone up to around USD 60 a barrel for Brent crude.

FT: Norway forms a large part of the Nordic high-yield market, and if we look at it in isolation, flows have stabilised. In January there was an influx of nearly NOK 1 billion into the Norwegian high-yield market. So it is clear that a more stable oil price leads to less uncertainty. However, we have not had any major exposure to oil and oil companies in Norway ourselves.

You said earlier that although you have not had much exposure to oil services, other things have been affected to oil prices.

FT: Yes. There are a number of debt funds in the Nordic region that are Nordic or exclusively Norwegian. When these experience outflows due to falling oil prices this affects the market in general, since they are forced to sell holdings from their funds to meet the outflows. If price changes to corporate bonds are purely based on flows, this is good for buyers with inflows into their funds. It’s important to be cautious when the credit risk in a company increases, but if price adjustments are driven purely by flows then there’s instead a buying opportunity.

Liquidity risk is always a key factor in the corporate bond market. Sometimes there is plenty of supply, while there can be considerable drought in periods when there is uncertainty in the market. Magnus Nilsson thinks he can detect a better balance in the market at the moment, with positive flows in both Norway and Sweden, while the primary market – relating to new issues of corporate bonds – is now more or less non-existent when it comes to the high-yield segment.

What has happened recently is that the major Swedish banks have issued what are known as CoCos, or contingent convertible bonds, in fairly large quantities. CoCos are similar to ordinary convertibles and are a form of bond that can be converted into shares, or be written down in value on predefined terms. Unlike normal convertibles, however, it is not the bond owner who decides whether or not the bonds will be converted into shares. Instead, the conversion is dependent (contingent) upon a specific event.

MN: Handelsbanken and Swedbank issued in February, and there is a high return on these bonds of 5.25-5.50 percent. Nordea and SEB also have outstanding bonds, but since these are denominated in dollars, much has gone to foreign accounts. In the Swedish– and Norwegian – market, supply has been very limited, while demand has increased, which has given a positive price spiral. We were able to see this in our funds in February. The Avkastningsfond fund returned 12 basis points in the month, Corporate Bond Flex was up around 80 points, and Credit Opportunity rose by 1.8 percent.

Is there any company that has recently issued that you thought was attractive to invest in?

MN: It’s been very limited. There was a big issue by a company with operations focused on personal care and special accommodation, a major supplier to municipalities in Sweden and, to some extent, in Norway that was refinancing SEK 1.7 billion. But the bond didn’t even reach the market and the banks took on that financing instead. It was too expensive for the company to turn to the market because the investors that might have been interested in buying wanted a high coupon.

According to Catella’s latest newsletter, the corporate bond market now has two tiers, with greater demand for investment-grade than for high-yield.

But there have been new signs in the past week – is the difference about to narrow?

MN: Yes, there is greater demand for high-yield bonds. This is because some of the investment-grade segment has become quite richly priced. We can see this particularly in the euro market, where companies like stable SCA are issuing five-year bonds at plus 50 basis points, or Euribor + 0.50 percentage points. This is a little meagre for some portfolios, so they seem to have intensified their focus from BBB down to BB, and in some cases even down to B ratings.

Catella’s newest fixed-income fund, Credit Opportunity, has the broadest investment mandate and can take the highest risk. The current yield of the fund presently amounts to 7 percent – and it’s up over 2 percent since the start of the year.

The duration of Credit Opportunity is three years, and the allocation of the fund is now about 25 percent investment-grade bonds, 65 percent high-yield bonds and also a small position in preference shares – about 5 percent.

When picking companies in different sectors, is there anything you prefer and anything you avoid?

FT: We continue to go on about avoiding pure project financing that lacks either a strong balance sheet or cash flow. We’ve seen this type of financing in the Nordic mining industry, for example, based on investment that has not been possible to finance, and dependent on a future stable commodity price that could not be met. So it’s mainly about the type of investment we choose to avoid.

Fredrik Tauson points out that in this environment, with an active central bank in Europe and negative interest rates in many countries, the hunt for yield will continue. This means that buyers of bonds are likely to drift downward in credit quality. The hunt will therefore move away from investment grade, down to BB, and eventually down to the B segment in credit quality.

Magnus Nilsson points out the returns at the moment on Catella’s three fixed-income funds. The Avkastningsfond fund, the most conservative, has risen 0.4 percent so far this year and the best guess of the managers is that this fund will end up at a return of around 1.5 percent this year after fees, while the medium-risk Corporate Bond Flex has a current yield of 6 percent, and the outcome so far this year is up 0.9 percent.

MN: We are hopeful of being able to deliver, according to our best guess, 4-4.5 percent, maybe up to 5-5.5 percent on the fund. Credit Opportunity, which is a high-risk fund within fixed income, has a current yield of 7.25 percent at the moment – and has gained over 2 percent in value so far this year. It is about where it should be, but it will move significantly more – and one may assume that there will be negative months with some frequency.

Magnus Nilsson summarises the situation by saying that oil prices appear to have bottomed out and even found their way back up slightly, which has provided support to the Norwegian market and some of the funds’ holdings.

MN: The economic cycle is decent and, I believe, ideal for corporate bonds. Firstly, growth is not too aggressive because then companies tend to go into acquisition mania and increase their leverage. Secondly, the alternatives are so bad, with money market funds that have assumed zero or negative returns, bond funds with very low yield and high duration risk, relatively limited supply, and demand which is successively increasing in the hunt for yield – together this bodes for a pretty decent comeback for equities.

You also work with derivatives to hedge the portfolios in Corporate Bond Flex and Credit Opportunity. How are you currently hedging?

FT: About two months ago we removed the credit hedges. Given the ECB’s bond purchases in the open market, we expected that the hunt for yield and demand for the holdings we have would increase. We work more with hedging when we expect some type of adverse event. To constantly be hedged is not an ambition in itself. In terms of interest rate hedging, ie duration, there is similarly no point in hedging against rising interest rates when central bank policy is as stimulative as it is now. If we see any more long-term trend, such as interest rates starting to rise, we will quickly intervene and reduce the duration back down.

In summary, we anticipate a relatively good year for corporate bonds, and the hunt for yield will lead to increased demand for bonds with lower credit ratings.