The covered bond market has been a great place to be if you are an issuer in the last twelve months. But what of the investors? Nordea Investment Management (Nordea) has been able to navigate the negative interest rates, poor allocations and central bank led distortions, to generate strong returns and become GlobalCapital’s Covered Bond Investor of the Year.
Whilst we all know that covered bonds are safe, low volatility assets, matching a benchmark such as the iBoxx Covered Bond Index isn’t likely to make any investors rich, which is why Nordea, offers their clients a range of options. At the heart of the range are low duration and high duration funds. Whilst they both invest in the same bonds, the low duration fund does so on a hedged basis to bring the duration down to one year – compared to the overall market’s more typical five year duration – for investors concerned about an overall upward movement in rates. Its telling that this year the low duration fund has surpassed the high duration fund in terms of assets under management, but as switching between the two funds is straightforward, many investors use the two as a way of tactically reflecting their short term rates views.
We’ve never had better liquidity, we get €100m bids on single ISINs and it is bids that are important to us
Another option Nordea offer investors is leverage – only one times leverage in their UCITS compliant fund but with repo rates so cheap it’s a way to even make a positive return from a negative yielding covered bond. And, according to Henrik Stille, senior portfolio manager, compared to other high-grade funds, it still represents a lower level of overall risk.
It isn’t just dedicated covered bond funds that invest in covered bonds. They also have an important role to play at Nordea in multi-asset funds alongside equities, commodities, FX and credit. In particular, Nordea sees a role for covered bonds where others would traditionally invest in government bonds for two reasons.
Firstly, according to the rating agencies, covered bonds can often be a better credit than government bonds from the same country. But more importantly, for Stille, they typically have a lower volatility. That works on a macro level – if you compare euro government bond market weight indices to the iBoxx Covered Bond Index, it is more volatile – but also on a micro level, the same could be said of the price volatility of French government bonds compared to French covered bonds, for example. And unlike other more volatile products you don’t get any extra alpha in return, with government bond yields mean reverting, their volatility is ‘just noise’.
The flip side of using covered bonds in other portfolios is using other asset classes in covered bond portfolios, governments, agencies or the new EU bonds for example, but, according to Stille, “only as a short term tactical view on value relative to covered bonds”.
But to have a good strategy for covered bond investments is one thing. Putting it into practice in today’s market, another thing entirely. But here Stille goes against received wisdom on liquidity. “I wouldn’t actually complain about liquidity,” he says, pointing to the fact that he can always find the offer side in the primary market and on the bid side. “We’ve never had better liquidity, we get €100m bids on single ISINs and it is bids that are important to us.”
Stille also points to the greater liquidity available in the Swedish and Danish domestic currency markets and his ability to switch between euros, krone or any G10 currency as an important factor to his ability to manage his position. “Being active in many different currencies has been absolutely necessary, without that we wouldn’t have been able to grow our funds or generate alpha,” he says.
Another factor that ameliorates the lack of secondary liquidity is the higher correlation between the spread performance of different issuers – the issuer that you chose to invest in isn’t what drives your overall return. Investors such as Nordea have a particular issuer name that they want to invest in less often in the current market than in the past.
Looking to the future Stille sees supply and alpha increasingly coming from issuers outside Western Europe, he has adapted his fund guidelines to reflect that and, for example, describes Poland as ‘still a very young market’. Whilst growth in these countries might be ‘on hold’ as a result of the pandemic and the many alternative sources of funding, he is confident that they will return to growth.