Interest rates have been steadily seeking out new lows for a long time now, but this has changed. All the signs suggest the low point has passed and we are facing a period of gently rising rates. Is it possible to make good investments in this new environment?
Catella Fonder has options for clients who want to bypass the volatile stock markets and the negative performance of traditional bond funds that invest in government securities.
Catella Fonder's fixed income portfolio managers Thomas Elofsson and Stefan Wigstrand, who look after the Credit Opportunity, Nordic Corporate Bond Flex, Avkastningsfond and, partly, Catella Hedgefond funds, believe that interest rates passed their low point the year before last. Central banks have since begun raising key rates, and quantitative easing (QE) has started to be withdrawn.
But interest rates are still very low in a longer historical perspective. The present situation is what the fixed income managers call asymmetric risk: rates cannot fall very far, but there is much greater scope for rises.
In the summer of 2016 the US 30-year bond yield hit its lowest point. Present levels are much higher, although from almost nothing, and the trend is clearly upward.
Thomas Elofsson believes it is unlikely that central banks will return to the aggression they showed after the financial crisis, or in 2015-2016 when there was a slowdown in the economy and QE was expanded. Swedish rates were cut to far below zero.
"The United States has taken the lead, and we can see that US rates have gone up considerably more while German and Swedish interest rates have not shifted as much. Where interest rates have been the lowest, in Japan and Switzerland, ten-year bond yields are now on the positive side at least, but this clearly cannot be normal in the long run. Even if interest rates remain low, they could be something like 1 percent, or 1.5 percent," says Thomas Elofsson.
There is a good chance of interest rates continuing to creep upward if the economy gains more momentum and inflation rises slightly. The US has already begun some repurchases, and it is trying to reduce the Fed's balance sheet, although this may take longer than some people predict.
Are there signs that the growth is not particularly resilient, or is this just extreme caution?
"There is a huge amount of caution. A gigantic experiment has taken place. Turning this around takes prudence, and there is a risk of falling behind, which would become apparent in much higher inflation numbers, forcing the pace to accelerate considerably," says Thomas Elofsson.
When it comes to the stock market and market sentiment, these are very much about expectations. Last year, growth was a bit better than expected, as were profits. The stock market rose and there was great strength in credit trading, while inflation was actually slightly lower than expected. As a result, central banks were able to remain highly expansionary. This will not be the case this year, the managers believe.
"If we had to guess, we think that growth expectations will stop being raised sometime this year – they may become lower. At the same time, inflation expectations may be upped. This environment, with growth not being a positive surprise and inflation not coming in below expectations, but just the opposite – this is a new environment. Quite simply a somewhat more challenging market," says Thomas Elofsson.
He emphasises that there is no big drama ahead, but rather a slow normalisation. Central bank balance sheets are huge and it will take many years before they regain a normal situation. One troubling question is whether there will be time to return to normal before things deteriorate.
The US is experiencing stronger growth, but this is at the cost of a rising budget deficit. Is this a risk?
"I think this is probably one of the biggest risks. It feels troubling to have such a large budget deficit this far into an economic recovery. We have a budget surplus in Sweden, but if growth slows considerably the budget will also suffer. Sweden could experience something like the crisis of the 1990s, with the budget suddenly getting much worse and forcing considerably more borrowing. There could be a situation of slowing growth and rising interest rates," says Thomas Elofsson.
The Swedish market has had strong growth for several years, and managed well throughout the entire period of difficulty that troubled other countries. But now Sweden has entered a phase of housing overproduction, with a risk of weaker growth as a consequence. The question is whether this will influence Riksbank governor Stefan Ingves' decision in the future. Thomas Elofsson does not anticipate any such clear link.
"Indirectly in that case. Because if housing prices fall the general feeling will be that people are a little less well-off and will consume a little less, thus weakening growth. And that could affect inflation, although the link is not entirely direct," he says.
What is the overriding factor: that Europe starts to improve and we have strong exports there from our companies, or that we have a housing problem in our domestic market?
"That depends on how bad things get. It would be a major factor if housing prices were to fall by 30 percent. But my feeling is that Europe's development is more important for Swedish key interest rates than the housing market. Even if growth has been 1 percentage point higher in Sweden due to so much building. If we turn that around and assume that there will not be as much building in future, it will not be a big deal for Ingves," says Thomas Elofsson.
The portfolio managers therefore do not regard housing prices as the main key to the future, but rather inflation. According to Thomas Elofsson, Sweden, and to a certain extent Norway and Denmark, have experienced a period of higher growth thanks to strong domestic demand. In the next phase, domestic demand could become weaker but external demand may instead strengthen. The environment can be described as good for Swedish export companies, especially when the krona has weakened again.
Looking into the crystal ball twelve months ahead for the Swedish Riksbank raises a couple of important questions. Firstly, whether it will end its support purchases, and secondly whether it will start to adjust interest rates. Thomas Elofsson does not anticipate the latter.
"It will be tricky for them to start to raise rates this year. But they are clearly signalling that they will stop the purchases, so we have to expect that. If they have the opportunity they will start trying to raise rates at the end of the year, otherwise they will postpone it until next year," he says.
How do the portfolios look and what are you doing, if we start with the Catella Credit Opportunity fund? Tell us a bit about the mix of investments – what would you like to see?
"As Thomas was saying, the conditions look different from last year. We had a different portfolio when entered the year and have continued to hold it. We have removed more of the high yield risk we had in the portfolios in general, and have also added some hedging against widening spreads in high yields," says Stefan Wigstrand, adding that roughly half of the portfolios consist of high yields.
A proven strategy with the managers is to try to diversify systematic risk, such as the fact that there is a large proportion of real estate and banking in the market. However, the idea of trying to create a portfolio that does not resemble the market portfolio remains unchanged. But it is not easy to achieve this, at least not in the Nordic region.
"This is one difficulty in the Nordic market, it is still relatively immature in terms of how many instruments there are and in terms of their sector spreads," says Stefan Wigstrand.
High yield corporate bonds are not all alike – the category can be said to consist of several subcategories; from distressed corporate bonds to companies that are close to an investment grade rating but for some reason have tumbled into the high yield segment.
The portfolio managers largely avoid the investment grade category because it is considered to offer poor payback, focusing instead on high yield and what they call 'opportunistic investments', which involve more short-term or risky transactions. Stefan Wigstrand says that, at best, these can achieve equity-like returns.
The managers work actively with duration and, with the fixed income components of Catella Credit Opportunity and Catella Hedgefond, are able to hedge the portfolios by working with derivatives.
Many market commentators believe that if interest rates start to rise it is not possible to find returns in fixed income. What can a fixed income manager do to gain a decent return in this interest rate environment?
"If you believe that long-term rates will rise then you cannot expect to make money from long-term government securities, but in more high-yielding corporate bonds where we try to keep quite a short maturity – somewhere between two and three years. There are more tactics when it comes to duration: there is an asymmetry of risk when rates are able to rise quite a bit but not able to fall so far. If interest rates creep down a little, we can hedge the interest rate risk. And even be negative in interest rate risk so we earn money from rising rates. That's how the portfolios look right now because interest rates have fallen on recent concerns," says Thomas Elofsson.
So this year you have you have had negative duration for some periods?
"Yes. At the beginning of the year we were very short and interest rates rose quite quickly. Then we closed that and were again slightly long on interest rate risk, but after this downturn we are back to short. So rising interest rates would benefit our portfolios. What we would be most vulnerable to is if growth were to become considerably lower, or inflation did the same," says Thomas Elofsson.
In a portfolio of different high yield securities there may be times when something doesn't quite work out. One company making the headlines in the Norwegian markets is Lebara, a telecom company that issues prepaid cards and that was bought by a Swiss owner last September. Since then, there have been questions about the financing that was put in place, especially as the company's profitability may not be as good as the market first thought.
Catella's fixed income managers have had to put a lot of work into this situation.
"When confidence get eaten away, and in this case quite seriously, it has big consequences as many investors choose to sell first and ask questions later. We have lost a considerable amount of money from this situation," says Stefan Wigstrand.
The Lebara bonds are traded on the market, and some investors believe that the events are a chance to buy in at low levels. Catella's managers are keeping a close eye on developments and will meet Lebara representatives shortly to discuss the way forward.
If we take the Hedgefond fund, you have written down Lebara by about 30 percent. How much is left, approximately?
"I would say there is about 90 million in the hedge fund," says Stefan Wigstrand.
By comparison, Catellas Hedgefond's total is just over 9 billion kronor. But if things get really bad for Lebara, and the company defaults, the question becomes whether we have collateral.
"We do have collateral, but as usual in these cases you have to ask what collateral is actually worth if things get really bad. But at least we have it. And this is important when it comes to negotiations, having the right cards," says Stefan Wigstrand.
Tell us about something that has done well and been a good investment?
"We have had a number of consumer credit companies and debt collection companies that are still performing well. We have completely divested some, but what we have left has continued to do well. We've also had chemical companies, which have been quite late in the cycle and are showing great results right now," continues Stefan Wigstrand.
Last year, Catella Credit Opportunity had great success with a return of around 6.5 percent, while Catella Nordic Corporate Bond Flex ended up at around 4.7 percent. The outcome was supported by some opportunistic investments and a well-diversified high yield portfolio. The question is whether similar successes can be achieved this year or if expectations have to be lowered.
"We have trimmed back our expectations a little because we had terrific luck last year with several transactions. We can't count on that every year. This year is a bit more challenging and, obviously, an environment with rising interest rates and higher volatility in the market makes it harder for us to create an equity-like return," says Stefan Wigstrand.
So, in a year like this one – without making any promises– what returns could be achieved on a flexible mandate? 5 percent or 4?
"In that ballpark. For Catella Credit Opportunity we targeted 7 percent last year and achieved 6.5 percent. This year we have said that 5-6 percent is achievable," says Thomas Elofsson.
Despite the environment of slightly rising interest rates?
"This is based on the fact that we lend to companies and get a decent return, so assuming that no adverse situations arise we should achieve this. But it is possible we could make poor choices of securities, and doing that too often is a bad thing. But, as I said, we are fairly upbeat about this year," says Thomas Elofsson.
And what should we expect for Catella Nordic Corporate Bond Flex this year?
"We have a slightly different mandate here, but our ambition is to achieve 3 to 5 percent this year," concludes Stefan Wigstrand.