Ever since the European sovereign crisis and the ECB’s strong counter measures we have witnessed yields trending down, posting record low levels over and over again. Corporate bonds are still offering attractive spreads over government bonds, but in absolute terms yields are at all-time lows.
To make life even harder for portfolio managers, the ECB expanded its quantitative easing program this summer to include corporate bonds.
Undoubtedly this has been good in terms of mark-to-market performance for existing holders of ECB-eligible bonds (in general, euro-denominated investment grade rated bonds issued by non-bank corporates) but the sheer size of the program has resulted in rapid tightening in spreads and a total drain of secondary market liquidity – if you try to buy bonds of course, but selling would be easier than ever!
Are we doomed to invest in zero-yielding corporate bonds?
After a post-Brexit rally in virtually all fixed income and credit markets, investors are scratching their heads wondering where to get any yield going forward, especially if one doesn’t like to add too much duration. While interest rates are at all-time lows across the curve, extending duration (increasing interest rate risk) is not rewarding investors anymore but is increasing risk significantly.
The reason is that rates have only limited potential to go even lower and offer positive return, but when rates get higher the investor loses accumulated performance quickly. For example, investing in long bonds with modified duration of seven means that the investor loses seven percent if rates rise one percentage point. For me, it sounds like risk is quite badly skewed to the downside when even the longest of German sovereign bonds are yielding less than 0.5 percent!
All hope isn’t lost, non-rated Nordics still offer a pocket of yield
Investors looking for short duration investments have quite limited options if positive yield is desired; money market and sovereign bonds are trading by and large at negative yields, investment grade offers some spread but also has quite high interest rate risk, and high yield is very attractive relative to other fixed income classes but many investors are not willing or able to take that much credit risk. One available pocket of yield remaining is the non-rated Nordic corporate bond market.
Many non-rated Nordic companies are fundamentally very strong, well-known names in the Nordics and many of them have their equity listed in Nordic bourses. Traditionally, non-rated bonds have not been followed or owned by investors outside the Nordic countries, and as the companies are not officially rated they have been issuing bonds with hefty premium compared to their rated peers.
Even though there are more and more continental European investors involved in non-rated bonds these days than there were in the past, these bonds are trading at a very wide spread to their rated peers. One frequent explanation for spread is liquidity, but during the last few years these markets have had equally good (or bad, depending on how you look at it) liquidity. Surely the scale of credit risk is as broad as it is in a European officially rated market, but for selective investors, picking fundamentally strong companies can produce very attractive risk-adjusted returns.
I have been favoring Nordic non-rated bonds for years due to the unique combination of strong credit fundamentals and attractive valuation. Applying the same investment processes, conservative approach and discipline that are used in other credit classes has resulted in strong but stable performance over the cycles. Sooner or later masses of credit investors will expand into this market and correct the valuation difference, but until then we can continue to enjoy abnormally good carry.