“Extremely strong beginning of 2019”
The Nordic credit market got off to a roaring start in 2019, with increased risk appetite and a large number of new issues. And Carnegie Fonder’s fixed income team continue to see opportunities in both high yield and investment grade, it was revealed in a round table on monetary policy, Nordic bond picking and increasingly green portfolios.
When we meet, Riksbank Governor Stefan Ingves has just visited Carnegie Fonder to talk about the latest monetary policy decision and the outlook for Sweden and the world economy before a packed Carnegie Hall at Regeringsgatan 56 in Stockholm.
Stefan Ingve’s message could be summed up in one word: okay. The world economy is chugging along quite well, Sweden is strong and inflation is moving ever so slowly in the right direction. However, the audience, which consisted of about a hundred institutional investors and pension managers, was generally sceptical.
How can Sweden have a negative policy rate after such a long period of economic growth? Why does the Riksbank not care that the krona is exceptionally weak? This gives a possible starting point for a round table with Carnegie Fonder’s fixed income managers when we get together a few days later.
But there are a number of highly topical issues that need to be touched upon, not least the fact that the Nordic credit market got off to a roaring start in 2019. After a turbulent 2018 which, just like the stock market, ended very weakly, 2019 has started with increased risk appetite. Carnegie Fonder’s fixed income funds have been well-positioned and, at the time of writing in mid-March, Carnegie Corporate Bond has risen by 1.6 percent and Carnegie High Yield Select by 2.4 percent.
If we sum this up with one word as well, it would be “bullish”.
So, there is plenty to talk about when we meet the fixed income team comprising Maria Andersson, Niklas Edman, Mikael Engvall and Mona Stenmark, plus credit analyst Daniel Gustafsson.
We have to begin with our guest speaker Stefan Ingves, who described the global economy as strong but now entering a quieter phase. The Riksbank raised the interest rate in December but it looks like it will be some time before the next hike, and some are even claiming the next move will be a cut. The Riksbank predicts that the next increase will come in the second half, but the market has learned to take these forecasts with a pinch of salt. How do you feel about Sweden’s current monetary policy? Mikael, what do you think?
– Mikael: “It is undeniably a special situation that the Riksbank is in right now. If it needs to stimulate through monetary policy this is hardly an ideal starting point, with a negative interest rate and a large proportion of government bonds repurchased. At the same time, Swedish inflation data has come in somewhat weaker than expected this year and the ECB [the European Central Bank] has signalled that it will hold off on further increases. Assuming that Swedish data allows it and inflation does not continue to surprise on the downside, I still believe that we could see an increase in the repo rate in 2019 up to zero. Then I think they will be more cautious and wait for the ECB’s actions before we see any further increases. But everything depends of course on how the economy develops.”
Stefan Ingves mentioned that the Swedish economy is still strong, not least thanks to the weak krona, we have to assume. How do you feel about the economy?
– Niklas: “Globally, we are seeing a certain economic slowdown, especially from China and Europe. At the same time, the leading central banks, the ECB and the US Fed, have been quick to communicate that they are postponing interest rate hikes and are open to additional stimulus, which has calmed the market and simultaneously fuelled risk appetite. It is also important to note that, from a credit perspective, it is not necessarily a bad thing that companies are bracing for worse times. Reduced investments and hopefully reduced dividends mean that cash flows have remained within the companies, which increases their ability to pay their interest. The business cycle is one thing to look at, another is the geopolitical risk like Trump, a trade war and Brexit.”
How do you manage risks like that when you are managing a portfolio?
– Niklas: “This kind of risk is difficult to predict, but we try to mitigate the effect of negative events like these by investing in shorter credits that reduce the market risk in our portfolios. At present, we have an average of 1.8-3.2 years in credit duration in our various portfolios.”
At this point we’ll leave monetary policy in order to look instead at what really interests you: Nordic companies and their bonds. What are you focusing in your management, and what attracts you to Nordic credits in particular?
– Niklas: “Our absolute biggest focus is credit risk, which means analysing and choosing the right companies, and this is also the biggest contributor to the return over time. Nordic credits are attractive on several parameters. Apart from the fact that the Nordic region is very stable, with a large number of excellent companies, we get better paid for Nordic credits compared to, for example, European ones, and without taking on higher credit risk. The reason for the Nordic premium is that we have a smaller market, we have local currencies, which many of the larger European and global investment mandates are unable to invest in, and it is less transparent. Being less transparent sounds negative, but it becomes a competitive advantage for us local players who know the market and the companies well.”
– “We have over 70 percent floating rate bonds in our portfolios. The Nordic region is very far ahead in terms of sustainability, which is a big plus as we see this type of risk as at least as important for the companies to consider as issues like currency risk. In addition, the Nordics are almost unique in the world in having a large share of bonds with variable coupons, which means that we have very low interest rate risk in the portfolios at the moment as we get a direct impact on the return from any raised interest rates.”
Mikael believes that the Riksbank could raise the interest rate later this year. What do you feel about that?
– Niklas: “I agree with Mikael in his analysis, but perhaps I have a more cautious view of potential interest rate hikes. The probability of higher Swedish rates has decreased since the ECB announced that increases will be postponed.”
Daniel, what is most important thing when analysing credits?
– Daniel: “We look at a very large number of different parameters when we analyse potential investments. On the one hand, we assess the business risk and like to see diversified business operations where, in other words, they are not dependent on, for example, individual products or customers. As far as the customers are concerned, we like to see long contracts or long and stable relationships. We also assess the financial risk, where we make our own conservative forecasts of the company’s sales and earnings. We are happy to invest in companies where both sales and margins can decrease somewhat from our conservative forecasts without this making us worried about the credit risk.”
– “We also look at the ownership structure and take into account any acquisitions and dividends that could increase debt levels. Here, we also try to influence the terms of the bond in that direction, which means minimising the potential for the company to increase its debt or make distributions to shareholders. Last but not least, we obviously also want to get well or properly paid in relation to the credit risk in each company and, since we are such a large player in the market, we often have the opportunity to express an opinion on the right price for new credits.”
Maria, you meet with companies almost every day. How are the Nordic companies doing and what are they investing in when they sell bonds, that is to say when they borrow money from you?
Maria: “From a credit perspective, Nordic companies are generally doing well. Sustainable investments are increasing and, for example, Stora Enso recently issued so-called green bonds for a total of SEK 6 billion. The capital goes to sustainable purposes and the market showed great interest in that bond. Stora Enso is a good example of a company that makes major investments in ESG-related projects [ESG = environmental, social and corporate governance], which is both desirable and necessary given that the company has historically had major shortcomings in this respect. Ahead of this transaction, we had the opportunity to meet Stora Enso and we devoted the whole meeting to talking about their unfortunate history of a lack of monitoring of suppliers. The company explained that in addition to investments in various products that can replace fossil-based materials, and environmental protection, they have also improved their methods of screening the subcontractor chain and discovering and quickly rectifying any deficiencies. As an example, their ESG representative is part of the executive management, which means that any signs of deficiencies are now directly reported to the top management, which can thus also act immediately. We liked the company’s new procedures and chose to participate in the green transaction.”
How much have you invested in green bonds?
– Niklas: “Green bonds are a segment that is steadily increasing in our portfolios, and to date we have invested just over SEK 2 billion.”
There are two sectors in the business world that are always topical, and Stefan Ingves also touched on them when he was here: real estate and banks. If we start with real estate, how is the Swedish property sector actually doing? What kind of opportunities can you see in the prevailing worries?
– Maria: “The real estate sector has enjoyed a period when all the stars have aligned. They have had low financing costs, while there has been some inflation that has allowed indexing of rental contracts, meaning rent rises, and we have also seen market values of properties soar. Many companies have reduced their debt levels during this period, which has actually been an effect of the higher property values. However, the companies have adapted their financial policies to the lower debt levels. This has generally been a part of acquiring credit ratings, which in turn enables more diversified and longer-term financing, where the companies can reduce their exposure to bank loans in favour of bond financing. This has meant that real estate companies now account for 50 percent of the Swedish bond market.”
– “In addition, many in this sector have looked outside the Nordic region and issued bonds in euros, at which point investors require a credit rating from one of the major rating companies like S&P, Fitch or Moody’s. But even though properties with lower debt are a good thing, we focus on the companies’ cash flow, and want them to have a good margin for both interest payments, including potential rate rises, and maintenance investments.”
Can you give examples of companies whose credits you have invested in?
– “One name that we like is SBB, Samhällsbyggnadsbolaget, which owns social infrastructure properties such as retirement homes and schools. In addition to stable counterparties in the form of tax-financed tenants, SBB also has long lease agreements, which provide strong and sustainable cash flows. SBB has also been on a journey, and is still on it, with its balance sheet strengthening and its credit risk decreasing, and the company is ultimately aiming to get a credit rating of BBB- or higher, which also means a very good journey of returns for us bondholders. For example, SBB is the holding that contributed most to Carnegie Corporate Bond’s performance in 2018.”
– “So, we like properties with low levels of borrowing, strong cash flows and, last but not least, comes capital tied up, which should be long and diversified, something we particularly look at since we believe that one of the biggest risks for real estate companies is linked to the refinancing of loans. If we finally look at opportunities in the sector, real estate is currently paying relatively high margins compared to other industries, which we find attractive and, if we can also participate in the companies’ journey towards a lower credit risk, the return could be really good. But it is a matter of being selective in what names you invest in, and here we do what we usually do and start with which companies we like rather than invest in a whole sector.”
Caution permeates all of Carnegie Fonder’s management, and you and Mikael seem the most cautious, Mona? You look especially at investment grade credits, which are those regarded as being the least risky. What opportunities do you see in the real estate IG segment?
– Mona: “One company we like is Vacse, a social infrastructure property company with a BBB+ rating. Vacse owns and manages properties for governmental agencies, primarily in the judicial system, but also in schools and other authorities. This means that the customer base is stable and the contracts are long, on average ten years, which creates stability. Another plus is that Vacse uses 100 percent renewable energy in its property portfolio and it has low borrowing.”
– “Another example is Akelius, whose focus is on residential properties in attractive locations in big cities. Akelius is a stable credit with a strong, diversified portfolio and it is striving to get a higher rating than the current BBB. We also like Heimstaden Bostad, which is rated BBB- and which issued a bond last autumn at an attractive level, especially in relation to its stable portfolio of residential properties in growing cities.”
The next sector is banks, which Stefan Ingves described as vulnerable and which you are not much attracted to either. What is it that makes you a little hesitant to bank bonds, generally speaking?
– Maria: “If we start overall, we will only look at the Nordic banks and will not invest in either Spanish or Italian banks. Banks issue many different types of bonds, and from time to time we choose to avoid some of these, and this is primarily because they provide too low risk-adjusted returns. For example, we have chosen to sell off or reduce our exposure to subordinated bank bonds, which means the bonds with the highest risk. Partly in order to reduce the risk somewhat after a very strong start to the year and, above all, because they do not pay sufficiently well in relation to the risk.”
You have reduced in Swedbank; why is that?
– Niklas: “We have reduced not just Swedbank but banks generally. The valuation is simply not as attractive anymore, partly because bond prices rose sharply at the beginning of the year, and partly because of the risks we see when it comes to, for example, investigations into money laundering. From a sustainability perspective, we are clearly cautious about who we lend our unitholders’ money to and what purpose this money is to be used for, so we await the investigations that are ongoing.”
If we look a little more widely again: If I understood correctly, the primary market has also got off to good momentum. There are a large number of new credit issues. Which industries or companies are most interesting right now?
– Mona: “Yes, after rather modest activity in January, things got going in February. We should add that the low activity in the primary market in January contributed to the strength of the secondary market since demand was high and pushed up prices. Investors’ interest has been substantial.”
What kind of companies are issuing?
– Mona: “It has been a mixed bag. Stora Enso, Volvo Cars, Hexagon Composites, Ica and Coor are examples of company issues in which we, in our various funds, have chosen to participate. In addition, Postnord, Golden Heights and Nobina have also issued in the primary market in 2019. Since the Swedish bond market is dominated by real estate companies there is often big interest in other sectors that can offer diversification in the portfolios. Then it is ultimately about the level at which the bond is issued. When there is great interest this can contribute to the credit margins becoming tight. Green bond issues are a niche where there is great interest and this is getting bigger.”
More green and not just real estate credits, then. Are you seeing any other trends in the market, Daniel?
– “We have seen quite a lot of M&As among our holdings, mainly with them being bought up. One example is mobile communicator Link Mobility, which was bought by a global media provider. This acquisition meant that the company’s bond was prematurely redeemed at a premium, giving us a very good return.”
Finally, we need to look more closely at what expectations we can have for credits in the near future. In the end, 2018 turned out to be a strong year even though it was so troubled at the end. The sharpest fixed income fund, Carnegie High Yield Select, rose by almost 2.5 percent during the year and has risen almost as much again so far this year, and the underlying yield is as much as 7 percent. What does this say about what expectations we could have for the fund’s future performance?
– Niklas: “To begin with, we are very pleased with 2018, when High Yield Select was the best fixed income fund in Sweden, even though the autumn and winter were really tough for the financial markets. The beginning of 2019 has been extremely strong, but if we assume a more normal market, we should be able to expect a return corresponding to the yield minus fees in the next twelve months.”
Carnegie Corporate Bond, the largest fixed income fund, has also had a good start to the year. What opportunities do you see here?
– Maria: “Yes, we have had a brilliant start to the year, and our Corporate Bond is already up by a whole 1.6 percent in mid-March. But given this together with various geopolitical risks, I think we should expect a return more in line with underlying coupons that the companies pay rather than for bond prices to rise particularly much more. With this in mind, I think a reasonable expectation is somewhere around 3 percent for 2019.”
Last but not least, investment grade. What return are you aiming to be able to get from Nordic IG credits?
– Mikael: “We entered 2019 with slightly better prospects for returns in the segment than in previous years. We had begun to get used to a starting position of a substantial negative interest rate, which meant that the credit margin paid by the issuers at best lifted the underlying return for IG credits to just above the zero line. However, at the end of 2018, partly as a result of the Riksbank’s interest rate increase, we saw an uptick in Stibor that affects the return on bonds with variable interest rates. In addition, companies were also forced to pay more for their borrowing at the end of 2018 as credit margins widened. 2019 has since begun strongly and, given the annual return in the segment, it is reasonable to have an expectation somewhere around 1 percent.”
In summary, we can say that despite the current low interest rates, investors can get around 1 percent at really low risk in investment grade credits and towards close to 7 percent by taking a little more credit risk through Carnegie High Yield Select. Thank you for talking to us!