The broad sell-off in the bond market due to geopolitical changes and aggressive central bank policies to fight inflation brings investors the opportunity of a decade. The Nordics benefit from a broad energy mix from own sources in the gas crisis. Nordic corporate bonds form a unique asset class here, with shorter durations and higher return expectations than comparable European issuers.
Investment grade and high yield bonds have in some cases fallen to levels where they offer equity-like returns in the next 12 months. The general market uncertainty currently still seems to prevent rational differentiation between issuers. However, a comparison of the economic environment shows that Nordic markets are much better protected against an intensification of the gas shortage than large EU economies such as Germany, Italy or France.
Especially the local industry on the European continent is suffering from the pitfalls of the electricity price mechanisms established in good times. In this crisis, Nordic companies are benefiting greatly from diversified energy procurement. It gives them a high degree of resilience against rising input costs and sourcing risks. Furthermore, the Nordic non-euro central banks are already a step ahead of the European Central Bank (ECB).
High energy prices and supply shortages are now keeping inflation rates high in Europe. Behind this is a war-related shortage of Russian gas. The ECB is trying to counteract the price pressure with interest rate hikes, although monetary policy can do little to change the situation. In the euro area, the market has already priced in additional ECB increases of more than 100 basis points for the next twelve months. Having said that, the October hike of 75 basis points is now expected to be the last jumbo hike. The market is expecting an additional increase of 50 basis points in December, after that increases are expected to be even more cautious, because of the fragile economic conditions in Europe. For euro-area companies, an immediate increase in the supply of electricity generation and adjustments to the merit order system of electricity pricing would be more effective help instead.
Current drivers for Nordic bonds
Central banks in Denmark, Finland, Norway and Sweden have already reacted to inflation early on with their monetary policy. As of today, they are closer to the end of the rate hike cycle than ECB. Their starting position was much easier. The four Nordics, Norway, Finland, Sweden and Denmark, also have a more sustainable energy mix and are not dependent on gas supplies from Russia. Of the Nordic countries, Finland used Russian gas the most last year. However, its share of total electricity consumption was not even 5 percent.
Electricity prices have also risen in the Nordics, but less dynamically than on the European continent. Moreover, the Nordic manufacturing industry is in many cases self-sufficient in energy consumption. Thus, their competitiveness does not suffer as much in the current crisis. Other important cost factors - such as wages - have also increased but remained moderate by international standards. The profit margins of the export-oriented Nordic economies and companies get an additional boost by an appreciation of the EUR/USD exchange rate by almost 20 percent this year.
Interesting for active investors
Investors therefore have little reason to worry about whether Nordic companies’ balance sheets have stayed healthy. Despite inflation and higher energy prices, credit quality at the corporate level has barely changed. Companies have been able to pass on inflation to their end customers in an appropriate manner. The Nordic bond market therefore does not appear to adequately reflect the positive trends as of today. There are major issuers such as UPM Kymmene, who last week issued a huge positive profit warning with earnings before interest and taxes (EBIT) doubled year-on-year in the third quarter, but whose bonds have seen their spread quadruple during this crisis. From a credit investor's perspective, there is virtually no risk that UPM will not be able to pay its bonds and refinance, no matter how deep the downturn is. Thus, the spread widening is difficult to explain fundamentally. Investors can still find such mispricings in many solid Nordic companies with superior balance sheet quality.
Non-rated investment grade bonds offer a particularly attractive counterpart in the Nordic bond market. Almost half of Nordic issuers are not rated by one of the leading agencies such as Moody's or S&P. Many international institutional investors cannot invest directly in this officially unrated part of the market. Also, companies with credit ratings in the borderline between investment grade and high yield, the so-called crossover segment, are not as interesting for the pure Investment Grade or High Yield investors. This again provides opportunities for the unconstrained investor. In this crossover area, both rated and unrated, active management and local know-how can add a lot of value. Many good 'crossover bonds' with ratings of BBB and BB can be found here, which usually offer higher risk-adjusted returns than comparable Eurobonds. Also of interest might be the fact that Norwegian and Swedish bond markets are not covered by the European Central Bank's purchase programme. In this respect, they are independent of ECB money flows. Also, Nordic local currency bonds are almost entirely floating rate notes (FRN) leaving the modified duration at very low levels.
ESG part of the Nordic DNA
The Nordic countries have traditionally been leaders in environmental and social responsibility. Together with the Netherlands, Finland was even among the first to adopt the ESG concept for financial investments. Almost all companies actively support investors in their ESG investments with information on compliance with international sustainability principles, ESG scores and CO2 emissions. This is especially true for Nordic bonds. When a company issues a bond, it already automatically provides a comprehensive ESG questionnaire.
Taking into account the specifics of the Nordic markets, investors can currently benefit from high, risk-adjusted returns at short maturities. Despite the issuers' sound fundamentals, the current yield spread is 450 basis points, which is twice the historical market average of 200-250 basis points and a rare occurrence indeed.
When at some point the bond market reverts to long-term spread levels and its historical equilibrium, it will provide European and especially Nordic corporate bond investors equity-like returns with a fraction of the volatility, implying once-in-a-decade risk-adjusted performance.