Key rates are on the way up and Riksbank Governor Stefan Ingves is expected to soon announce the central bank's first interest rate increase in a long time. The question is how much the rate will have time to rise, as the economy is already showing signs of cooling. Catella's fixed income funds are focusing on how the spreads – the interest rate difference against government bonds – will develop. According to the fund managers, there is currently too little compensation for taking risk in corporate bonds, which makes it likely the spreads will widen going forward.
The expected decision to increase the repo rate is expected to come either very soon, by December, or by February next year. Outside pundits believe that would be too late and would have liked to see increases sooner.
But Catella Fonder's Thomas Elofsson, co-manager with Stefan Wigstrand of Catella Avkastningsfond, Catella Nordic Corporate Bond Flex, Catella Credit Opportunity and the fixed income portion of Catella Hedgefond, does not want to focus on whether or not the increase is late. The unfortunate aspect of the Riksbank's actions, in his view, is that the central bank ended up taking the key rate down as far as -0.5 percent, where it is today.
"The bank has pursued an extraordinary policy when there was no extraordinary situation and has concentrated too narrowly on inflation. Inflation has now risen and they have no choice but to raise interest rates. I think they should probably have had slightly higher rates from the outset: if they had lowered the repo rate to zero instead of minus one-half percent, it would probably not have made much of a difference," he says.
Stock exchanges all over the world have been shaky since October and if the stock exchange is used as an economic indicator, there is much to suggest that a slowdown is on the way. The question is whether the Riksbank and the ECB will be able to keep on top of the situation. That is doubtful, according to Elofsson, who notes that the US has already raised the benchmark interest rate and tightened the belt. On American soil, they understand that growth is cooling down, especially in interest-sensitive sectors like construction and the automotive industry. China is also weaker than before.
"The business cycle has been chugging along for a pretty long time now. I am not overly worried that rates will go up by much, since I do not believe they will have time to raise them that much," says Elofsson.
For China's part, the country's economy is being weighed down by the ongoing trade war with the US, which has led to import tariffs being imposed on vast quantities of goods. The Chinese economy is closed and interest rate formation in the country does not occur in the same way as in the west, but according to Elofsson, one possible consequence of the trade war could be that the country sells US treasury bonds - something China has huge holdings in.
"That is a potentially effective financial weapon at their disposal," he says.
Studying US short- and long-term rates is a common way to try and assess the risk of an approaching recession. When long rates are lower than short rates, a recession is often imminent, within six months to a year.
"This is one of the classic things where predictability is good. As things stand, the curve looks pretty flat and we are looking at a situation completely different to what we have been used to: we should expect growth to slowly weaken a bit," says Elofsson.
The opinion among Catella managers has been that the likelihood of recession is low, partly due to the very low interest rate level. Historically, recessions have been preceded by an interest rate level higher than the nominal growth rate. This is not something we believe will happen in the next few years. "We are not really worried yet. But based on what we saw after the market dips in October, and that credit spreads widened even more in November, we are getting a little more uneasy. The basic tip is still that things are slowing down and that this is more than an adjustment" says Elofsson.
Bond spreads are widening in both North America and Europe, and the same trend is expected in Sweden. But the clearest sign that the market is changing – an increase in business failures – has thus far not been seen to any appreciable extent. Defaults are at record-low levels, partly due specifically to the low interest rates that make it easier for companies to repay their loans. But Stefan Wigstrand points out that defaults are reported successively and with a certain lag.
"Default rates are retrospective. That means you probably must take the significant widening of the spreads seriously. As a signal that defaults are going to go up," he says.
Other than Catella Avkastningsfond, which mainly holds investment grade bonds and has very low return levels in the current market, the fixed income funds presently have relatively low investment grade weights.
"We believe the compensation for taking risk is a bit too low and think the spreads are going to widen. In that situation, investment grade becomes highly vulnerable because spreads are tight there – there is no tolerance for a lot of spread-widening. So, we are trying to avoid that to the best of our ability," says Elofsson.
Looking ahead, sharper focus will instead remain more on bonds in the high yield segment. Here, the managers try to avoid bonds with the longest durations.
"In that case, we believe that even if the spreads widen, bond yields will compensate for a spread-widening," says Elofsson.
So, you are saying it is better to stay away from the Investment Grade segment until the spread has widened and you get a better offer. And when that happens, you can also choose IG bonds?
In the high yield segment, the managers have aimed to create portfolios that behave differently to a hypothetical market portfolio. This has been done by means including mainly avoiding property bonds, which are otherwise ubiquitous – about half the market consists of various property financing arrangements, according to Wigstrand.
"Growth in this segment has been relatively strong in recent years, which is why we believe the market is relatively satiated with that type of risk. Both in the banking system and the capital market. The companies have undergone powerful growth, valuations have gone up and there have been numerous transactions. That has forced the companies into the international capital market to finance their operations," says Wigstrand.
Property, with a base in physical assets, represents security to many. But the best assets are usually held by the banks, although bondholders have to accept a lower degree of safety. According to Wigstrand, conditions for property companies looking to borrow have become considerably tougher just in the last few weeks.
At present, Catella's fixed income funds have about 10 percent of their portfolios in property, compared to perhaps 50 percent for the market in general. Wigstrand explains that this is due to having avoided the sector for a long time.
"We have taken our property exposure opportunistically in the secondary market. There have been situations that were a little unusual, where we believed that investors were paid better for the risk," he says.
Let us say things get bad in the property market. Will you do better in that case?
"Our reasoning is not actually based on nervousness about the real estate per se, because as long as the economy is growing, property will be a good asset. It is more of a technical issue: there are so many property bonds and if the situation deteriorates, with outflows in credit funds, a lot of property is going to be put up for sale," says Elofsson.
Banking is the other sector that is big in corporate bonds. What are you doing there?
"We are going to sound very defensive now...but banking is also a sector in which we have invested very little," says Elofsson, and continues:
"It is the same thing there: we do not see any serious problems with Swedish banks and the reason is of a more technical nature. There are problem banks, especially in southern Europe, and the risks have to be repriced, which also affects Swedish banks.
"As Catella's aim has been to create a portfolio that performs differently, we have thus avoided property and banking and spread the holdings to other sectors. According to the managers, they are often looking at private equity-owned companies – who are the issuers of quite a few bonds – and they are often relatively non-cyclical companies."
To compensate for the risk taken in high yield bonds, Catella's fixed income funds also maintain relatively high cash reserves. About 25 percent, in some cases up to 30 percent, of fund assets consist of cash-like assets.
You have said that you are relatively confident about the economic trend. After the fact, would you say that has cost a fair bit?
"Yes, but we think it is worth it to maintain the flexibility that brings. We have saved the cash so that we can take action and avoid being too defensive in such a market scenario," says Wigstrand.
2018 has not been a particularly successful year for the fixed income funds. So far this year, the managers are at a small plus in Credit Opportunity and small minuses in the other two funds. Thomas Elofsson agrees that performance this year has been weak and refers to two main reasons.
"First, we have had a bond in (the virtual operator) Lebara, which has delivered very weak performance. And as we started out the year, we might have had an even more positive economic outlook - we were short duration, which did very well in January, but then interest rates went down. We were not completely wrong in our analysis, as US rates continued to rise during the year, but the outcome was poor due to falling European rates," he says.
However, the targets stand for the next year, which for the Credit Opportunity fund is to generate return of 3 to 5 percent - the same return target as for Catella Hedgefond.
If interest rates are now going up, must the duration tool be strong in order to move in the range of -5 to +10?
"At any rate, that creates opportunities to make money on an interest rate upturn," says Elofsson.