A corporate bond portfolio can look well diversified at first glance while still relying on only a few return drivers. Investing in structurally different markets can add diversification, writes Portfolio Manager Noora Launonen.
Corporate bond investors typically diversify across issuers, sectors, geographic regions and credit ratings to avoid relying on any single source of risk. Judged by these measures, many portfolios appear well diversified.
However, many portfolios may still rely on a relatively small number of underlying return drivers. This is because large segments of the credit market are connected through common benchmarks, investor bases and investment constraints.
Holding a large number of bonds does not necessarily mean that a portfolio is diversified across underlying risks and return drivers. For diversification to be truly effective, a corporate bond portfolio should also include exposure to structurally different markets.
Market structure matters for diversification
In our latest white paper, we examine how market structure can influence portfolio diversification. Does it matter how bonds are issued, who can own them, how liquid they are or whether they are included in benchmark indices?
We examine this through the Nordic corporate bond market, focusing in particular on its unrated segment. Unlike in the European and US credit markets that dominate most corporate bond portfolios, key characteristics in the Nordic market are not as tightly linked. Credit ratings, currencies, fixed- or floating-rate structures, investor bases and benchmark eligibility do not necessarily go hand in hand. This makes it possible to analyse the effects of market structure separately from conventional credit and interest-rate risk.
Market structure is clearly reflected in the pricing of Nordic corporate bonds. Even after accounting for traditional factors such as credit risk and duration, investors demanded different yield spreads depending on how easily a bond could be traded and whether it paid a fixed or floating rate.
Market structure also shapes how different corporate bonds behave during periods of market stress. During the 2022 interest-rate shock, Nordic unrated bonds lost considerably less value than Nordic investment-grade bonds, which carry high credit ratings. During the 2020 credit shock, however, unrated bonds suffered greater losses. This suggests that market structure does not eliminate risk. Rather, it changes which risks matter most in different market environments.
One of the key findings of our analysis is that the portfolio benefit from Nordic corporate bonds came from diversification rather than statistically significant excess returns. Nordic high-yield and unrated bonds offered combinations of risk and return that conventional benchmark markets could not fully replicate. This diversification benefit may persist because rating requirements, benchmark eligibility, small issue sizes and liquidity constraints prevent all investors from accessing the market on equal terms.
As a result, exposure to Nordic corporate bonds improved portfolio risk-return trade-offs and expanded the historical efficient frontier. In other words, adding these bonds to a portfolio made it possible to achieve either higher returns for the same level of risk or the same return with less risk.
Look beyond traditional measures of diversification
The number of bonds in a corporate bond portfolio says little about how many independent risks it contains.
Issuers, credit ratings, sectors and geographic regions describe how capital is allocated across securities, but they do not necessarily reveal whether a portfolio is exposed to different underlying return drivers. Diversification should therefore be assessed not only by the number of securities or other traditional measures, but also by the variety of risks that drive portfolio returns.
Although our white paper focuses on the Nordic market, the diversification benefits created by market structure are relevant beyond the Nordic region. At the same time, the results highlight Nordic corporate bonds as an effective source of additional diversification.
Many institutional investors already have exposure to Nordic corporate bonds. However, the exposure is concentrated mainly in rated, euro-denominated and benchmark-eligible bonds, which most closely resemble the broader European credit market.
Capturing a broader set of diversification benefits from the Nordic corporate bond market generally requires exposure to unrated and non-euro-denominated bonds. The appropriate approach ultimately depends on each investor’s objectives and risk tolerance.
White paper: Beyond Credit and Duration
Dive deeper into the topic in the Beyond Credit and Duration white paper and find out if a well-diversified corporate bond portfolio still can be missing something.
Explore our Nordic fixed income funds:
Evli Nordic Senior Secured Loan
Before making an investment decision, investors should familiarise themselves with the fund’s statutory documents, including the fund rules, the Key Information Document (KID), and the prospectus. The fund’s statutory documents and further information are available at www.evli.com/funds. The value of an investment may rise or fall, and investors may lose part or all of the capital invested. The content of this article should not be regarded as investment advice and should not be relied upon when making investment decisions. Past performance is no guarantee of future returns.
