Positive returns on investment-grade bonds have been hard to come by in the West. The Nordic market is one of the few exceptions, says Michael Weidner, head of European fixed income for global asset manager Lazard Asset Management. He especially likes Danish mortgage bonds.
‘Nordic bonds are a market segment with high credit quality, high liquidity and some extra yield without additional risk,’ he says. For Weidner, this market is one of the ultimate safe havens for risk-sensitive bond investors.
The interest in investing in Nordic bonds has recently increased, Weidner says. ‘They see our fund, the Lazard Scandinavian High Quality Bond Fund, as a better alternative to cash. Our investment strategy has had a volatility of 1.2 to 1.3 over the past two years and has posted an annual return of just over 1%. Other strategies with a similar volatility today post substantially negative returns.’ For Weidner, it is difficult to say whether this increased interest will continue, especially now that volatility in interest rate markets has increased.
‘There is speculation about an increase in inflation but it is very unlikely that central banks will raise interest rates any time soon.’ However, Weidner has few inflation concerns. ‘There is a significant chance that we will see inflation in the US, but in Europe the chance is much lower. And over the last 10 years, inflation in Sweden, Norway and Denmark, like economic growth, has already been higher than in the eurozone. So, if inflation were to rise a bit in those countries, it would not be that unusual. And there are independent central banks in place that will react quickly and take timely measures. On top of that, I am following a rather short duration strategy today. In other words, the impact of rising inflation, which is not good for any bond strategy, will not be the end of the world for us.’
Mortgage bonds
Lazard Scandinavian High Quality Bond Fund’s portfolio invests in all segments of the Scandinavian bond universe but the main allocation consists of mortgage-backed callable bonds in Danish Krone. ‘This has been a fairly popular market segment in recent years. It has some very attractive features: an AAA rating, a yield that fluctuates between 1 and 2% and they are callable bonds, which makes them quite complicated. For example, their price partly depends on the probability that they will be called on a quarterly basis, either in whole or in part. It is not easy to manage and model, but if you have a well-developed valuation model, you can generate a good return.’
The Lazard manager points out that if there is a lot of interest-rate volatility, as there has been in the past few days, the price fluctuations can be significant because the underlying option is much more volatile than usual. ‘In the past few days, when volatility suddenly increased, we increased our exposure to it because the spread widened. And it is likely that we will increase our allocation even more.’
Between 40 and 60% of the fund’s portfolio is invested in this type of bond, with the rest spread across corporate and government bonds. ‘The second part of the portfolio effectively flattens out the risk of the Danish callable bonds, making the latter much more stable from a risk/return perspective. After all, they have a negative convexity and that is not favourable when interest rates are volatile. A stable interest rate environment is perfect for this type of paper because then you can earn a 2% carry,’ he emphasises.
High-yielding Norwegian bonds
Scandinavian bonds account for only 1.8% of the Barclays Global Aggregate Bond Index. ‘However, if we also look at Scandinavian issuers who issue in foreign currency, the universe already becomes a bit wider. All in all, this adds up to a universe of 2,000 billion dollars, which is ultimately large enough to implement an active allocation policy’, Weidner points out.
Today, the manager finds Norwegian government bonds relatively interesting. ‘Interest rates have risen quite sharply over the past 2.5 months. The Norwegian 10-year is already hovering around 1.5%, which is quite high compared to other European countries. And after hedging the currency risk, which costs 80 to 85 basis points, there is still sufficient return left. By the way, this is the only market where we sometimes consider taking currency risk. The cost of hedging there is substantial while the Norwegian central bank is easier to assess than, say, its Swedish counterpart because it communicates very openly.’
Weidner mostly stays away from Swedish bonds these days. ‘The spreads on corporate bonds are far too narrow, even more narrow than in the euro bond market,’ he says.