Can fixed income hedges generate returns when rates are negative?

Despite the unusual interest rate environment, the managers try to invest in securities with an expected positive return. At present, this is a challenge – in the past, with interest rates of 10 percent, it was easier to generate a return than now that yields on government bonds are negative.

Government bonds are not a realistic option for investors seeking returns. The interest rate situation has even impacted what are sometimes termed “better credits”, corporate bonds with an investment-grade rating, as these are often traded below 1 percent – even though they are an investment with some risk.

“If the market catches a chill and credit spreads widen a little, that return disappears. You have to take more risk to be able to generate a return,” says Thomas Elofsson. 

These risks include the prospect of a weaker economy and of individual companies getting into trouble – the fact that they have a high yield rating is because they are seen as shakier than investment grade companies. To protect themselves, the portfolio managers use various hedges.

“This might be in the currency market or interest rate risk. We often have a hedge on the stock market since the co-variation between high yield and shares is often quite high,” says Elofsson.

The funds aim to achieve absolute returns, and the question is which instruments can be used to create positive returns in this situation. The fact that interest rates have recently fallen further does not make the job any easier, but with reasonable risk-taking and a good hedging strategy, Thomas Elofsson says it is possible to minimise the damage if the economy encounters tougher times.

“Obviously, there is a cost, so the return is not quite as large during the good times, but we think it is sound over time. The focus is a positive return, and this comes mainly from investing in things that have a high running yield;” he says.

Over the past three years, Credit Opportunity has had a total return of 11.9 percent, and for 2019 it is actually 3.8 percent so far. Since the fund was opened in 2014, there has not been a single year of negative returns – although it was a close-run thing last year.

“Last year was tougher for us and we just managed to create a positive return, which was well below the expectation we had at the start of the year. This was due to a number of factors, but we have kept to the strategy we laid out from the beginning,” says Stefan Wigstrand.

Catella Credit Opportunity has an extremely flexible mandate, which means the managers have a very free hand when choosing what to invest in. This flexibility, they say, is essential for success under the current challenging conditions.

“You have to be able to do things that go beyond the usual fixed income management. In an ordinary year these hedges either cost money or reduce the returns, but in weak years you recoup some of that,” says Elofsson.

The managers describe the activity in the fund as high – it is moving in an environment that is quite illiquid, and the dream scenario for an investment is that you can hold the securities for a long time while the interest ticks in.

“Then they get shorter and shorter because they are fixed income securities, and at some point you sell them and buy longer ones. If you experience a market downturn and want to increase the risk, it can be difficult to buy the quantity of securities you want. Then we are able to manage this elsewhere, in the hedge portfolio,” notes Elofsson.

He adds that it works in a similar way in the other direction – if the market has been very strong for some time it tends to move towards an average value, at which point the managers take the opportunity to ease off the hedging a little. The total risk in the portfolio is adjusted according to the market situation.

Investments in high yield bonds work well in many different environments, but tend to be worse during tough economic times. When companies get into trouble, a higher risk premium needs to be charged, and if the manager has invested in companies that have real problems it gets even worse – defaults when money gets lost.

So far, the number of defaults in the market is low, even historically compared to a “normal” market. But the fact that interest rates have dropped so dramatically in recent times shows that there is concern about a much weaker economy, and this trend determines whether the number of defaults moves upward.

“If there is an economic slowdown and it can be met with stimulus from central banks or with fiscal policy to avoid a deep recession, there may not be particularly many defaults. But how much extra do you get paid for taking additional credit risk far out on the scale? This extra compensation is very low,” says Elofsson.

He points out that the market currently has a somewhat strange way of pricing the situation: If you trade in interest rate risk or government bonds, the market seems to be pricing in a recession or perpetually low growth. If you instead look at more risky assets, high-yield credits or equities, the market does not seem to have any expectation that we are heading for a recession.

One explanation why the number of defaults is low, and can be expected to remain relatively low, is precisely this low interest rate environment. Companies do not have to be particularly successful in order to pay off their borrowing – as long as there is some profit, they can meet their payments. On the other hand, if interest rates were significantly higher, many more would be affected by payment problems, but since interest rates are generally controlled by central banks that are willing to continue with expansionary policies, this risk is limited.

“The prospects for reaching agreement and pushing the problems into the future are quite good, and the credit market is using this to its advantage. You almost never come to a place where companies go to the wall, and solutions are found,” says Wigstrand.

In recent years, many foundations and institutions have broadened their investment mandates to include investment grade, which has contributed to today’s extremely low returns on these securities. This means that investors are being forced further out on the scale to achieve returns.

“What’s needed to generate the return and create some form of basic tick in the fund is largely the high yield portfolio. We say ourselves that it has some form of single-B risk if we talk in rating terms,” says Wigstrand.

He adds that the yield depends on the composition of the portfolio, but that Credit Opportunity tries to create a high yield portfolio that is not too similar to the market portfolio. “It is important for us that it performs in a slightly different way,” he says. For example, the fund’s element of real estate credits is small, while there are large amounts of real estate and bank bonds in the market.

“If you want to create a portfolio that does not look the same as the market portfolio, then you have to look at basically everything else. The high yield component of the fund is perhaps 60 percent today, the rest is AAA – i.e. government securities or equivalent credit risk,” continues Wigstrand.

He says that the high yield component has a portfolio tick of around 6-7 percent, which in plain text means that these are securities with a relatively high risk. The fund manages this by having substantial liquidity in the form of secure liquid investments – partly to manage liquidity risks and partly to be able to participate in various market climates. Liquidity is around 40 percent – a very high percentage, which creates freedom of action to permit a balanced and stable return over time.

Is there any chance that interest rates will start to rise going forward?

Thomas Elofsson points out that worse times have often historically led to lower interest rates due to central bank stimulus, and spreads have widened and riskier investments have performed more weakly.

“What is challenging right now is that if there are better times ahead, interest rates will most likely go up. It may not be that the high yield bonds fare well from this. There will be better cash flows for companies, but the extra compensation you get today is so compressed that it may not be a favourable environment. On the other hand, if there is significantly worse growth, there is not much the central banks can do – they cannot lower interest rates much from this level,” he says.

Thus, in a good scenario for the economy, interest rates are likely to go up, while a bad scenario will probably lead to more expansionary fiscal policy and also higher interest rates. But in the current situation, with the economy neither really bad nor really good but where central banks are aggressive, interest rates may stand fast or perhaps go down, says Elofsson.

Most factors therefore lean towards a continued relatively favourable environment. But if there is wage inflation and interest rates go up, we should be quick to get rid of interest rate risk and short it.

“This is where other hedging opportunities come in: We have had a currency position for a weaker krona. If things get very much worse, it is reasonable that the krona will continue to weaken. Even though the krona is weaker than ever, and the Riksbank has for a decade predicted that it will strengthen, this is not happening,” says Elofsson.

You have had substantial variability in the duration and moved in the range between minus 2 and plus 4-5.

“This is a combination of what the rest of our portfolio looks like, what market belief we have in the short term and, most importantly, how much are we willing to hedge and what the right hedge is,” says Elofsson.

Credit Opportunity has an unusual element for fixed income funds in the form of put options on the stock exchange. This is a choice the managers have made because the put options are more liquid and easier to manage than hedging instruments in the fixed income market.

According to the managers, this hedging has cost a bit since the stock market turmoil in the summer and the subsequent upswing. However, having hedges when the stock market is close to its record levels and there is high demand for credit feels like safety, they believe, and they intend to stick to this strategy. “If the stock market slumps, we will remove the hedge,” says Elofsson.

In the choice between generating a little extra return or minimising the risks, Wigstrand says that it is crucial to try to avoid the heavy losses – especially as the upside is limited with fixed income instruments.

“This is number one: Designing portfolios for when it goes wrong – which happens sometimes – doesn’t cost too much,” he says.

Among the individual holdings at present are credit management company Hoist Finance, which is the fund’s largest single high yield bond. The company’s business concept is to take deposits from the public and use the capital to buy up overdue receivables. Hoist was hit by new regulations introduced by the Swedish Financial Supervisory Authority at the start of the year, which caused the share price to reverse quite sharply, although it has since recovered some of this.

“We found an interesting opportunity to buy a junior fixed income instrument in Hoist when there was quite substantial turmoil. The coupon is 8 percent, I think we bought it just under par,” says Wigstrand.

Another holding is Recipharm, which is a contract manufacturer in the pharmaceutical industry. In this case the fund owns a convertible, a fixed income instrument that provides the opportunity to buy shares at a predetermined price.

Looking at the corporate bond market as a whole, there are currently a large number of bonds in the US that have investment grade status but are just on the threshold of high yield – this segment accounts for about 50 percent of the market in the United States, while in Europe it is about a third of the total market. One concern for the future could be that a weaker market leads to these companies having a high yield classification, which would force many portfolio managers to sell.

A large number of companies have increased their debt over a succession of years, and the same applies to the companies in this rating category. Many that have previously had a better credit rating, such as A or even AA, are now at the lowest investment grade level of BBB.

“A downgrade to high yield is normally very costly for companies as financing costs become completely different. This is a risk that we have not really seen before – even if it is a risk that people are not losing sleep over, it is worth keeping an eye on. We think the entire investment grade segment has very tough pricing,” says Elofsson, and Stefan Wigstrand agrees.

“It’s always a question of what risk and price you get. The pricing of investment grade is fairly tough right now, and from the investment side we wonder if it doesn’t make more sense to create a portfolio of unrated companies or companies with high yield ratings, and try to generate returns that way,” he says.

Thomas, a few quick questions. US interest rates, will they rise?

“No.”

Will the Fed cut rates?

“Yes.”

The Swedish Riksbank’s next move, lower or higher?

“They had an opportunity when inflation was a little over 2 percent, but now it looks significantly worse – unemployment has risen and we are seeing a slowdown in the economy. They are talking about raising at the end of the year, but I find it hard to see that. If growth becomes very much worse, I do not think the Riksbank will cut interest rates very much either – and if they do, it will hit the krona much more than the fixed income market.”

Stefan: You have a five-star management rating from Morningstar and an extremely flexible mandate. What is the target return?

“We usually decide the target return every year, and for this year we said 4 to 6 percent. We are not there yet, but the year is not over either. If we have 60 percent in a high yield return portfolio that gives maybe 7 percent, this contributes just over 4 percent to the whole. Then the question is what can be shaken from the rest.”

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