Increased interest in corporate bonds

But there is no lack of storm clouds, one being the British referendum on the EU and another Chinese growth.

This is according to Catella Fonder's fund managers Magnus Nilsson and Fredrik Tauson, reviewing the fixed income market in a podcast.

The corporate bond market has improved markedly since January. One obvious reason is the decision by the European Central Bank (ECB) to start buying corporate bonds. The bank will buy higher-rated investment grade bonds, only euro-denominated securities, with a minimum BBB rating from agencies Moody's, Standard & Poor's or Fitch.

The decision has already managed to turn sentiment in the corporate bond market despite the fact that purchases actually begin in June. The ECB expects to buy volumes of EUR 5-10 billion per month, which is slightly more than the market had expected.

"To put this in perspective, the volumes issued in the market in 2014-2015 were just over EUR 200 billion, so this is considerable proportion of the potential primary market. In addition, the ECB will not only buy in the primary market but also in the secondary market, primarily in France and the Netherlands," says Magnus Nilsson.

Magnus Nilsson manages three funds jointly with Fredrik Tauson: Catella Avkastningsfond, Catella Nordic Corporate Bond Flex and Catella Credit Opportunity.

Of these, the Catella Avkastningsfond is the most cautious. Its holdings are mainly investment grade corporate bonds, but the portfolio includes government securities and some high yield bonds. The investment grade holdings, including cash and equivalents, currently account for 93 percent, with cash and equivalents at 8 percent. The duration is just over a year and the running yield is around 2 percent before fees.

"The target return for the next twelve months is currently somewhere around 1 percent, and the year to date return is currently just under a half percent, so we are roughly in line with what we said at the beginning of the year," says Magnus Nilsson.

The Catella Corporate Bond Flex fund has approximately twice the running yield and duration of the Catella Avkastningsfond. Its running yield is now 5.5 percent before fees and the duration is 2.2 years. The fund has 40 percent in investment grade instruments, including triple-A rated mortgage bonds. High yield securities account for 45 percent and cash and equivalents for around 15 percent.

The last fund, Catella Credit Opportunity, has a running yield of 7 percent before fees and its duration is just under two years. The investment grade component is 20 percent, and high yield accounts for 60 percent – in addition, approximately 10 percent of the fund is in preferred shares and 10 in cash and equivalents.
According to Magnus Nilsson, volatility in the funds has been higher than many investors are accustomed to, partly because of developments in China and the changing signals from the US Federal Reserve.

"Market volatility has increased, and this includes investment grade. In the past it has been possible to have these as fairly passive holdings, and I think this is still possible but it may be necessary to have a longer investment horizon to avoid being forced to sell at times when the market is most stressed," he says.

The Catella Credit Opportunity fund has risen by around 50 basis points since the start of the year, while Corporate Bond Flex is in negative territory and is down 1.7 percent since the beginning of the year, with the large decline having occurred between January and March.

"Since then we have been working our way back, and the goal is obviously to get back above zero. The fund has never had a negative year, and we do not expect to have one this year either. We are quite happy with how we acted during the downturn, when we reduced risk, especially beta risk," says Fredrik Tauson.

In addition to the ECB's decision to buy corporate bonds, a number of other factors have naturally influenced market appetite. One such factor is the oil price, which recovered from the lows of just above USD 27 per barrel paid for Brent crude in January. Oil is now trading above USD 50 – largely without OPEC involvement.

"It feels like the price of oil has found some kind of floor, which has led to improved risk appetite overall. Including for other asset classes, such as high yield bonds and equities," says Fredrik Tauson.

A more worrying factor affecting the market, and soon likely to have greater impact, is the upcoming UK referendum on EU membership. Until now most indications suggest the country will remain in the EU, but recent opinion polls are showing the vote will be very close.

The question is how a possible British exit would affect the country's development and, perhaps at least as important, how it would affect the rest of the EU in the longer term.

"Short-term impacts will probably be limited to British assets, with weaker sterling and higher interest rates being obvious goals. The issue of European polls suggesting other countries want to leave the European project will then be highlighted. There will certainly be populist politicians grasping this issue and driving it forward. The union itself will be weakened if the UK leaves," says Magnus Nilsson.
China, which has frightened investors at regular intervals in the past year, also continues to affect the markets, says Magnus Nilsson.

"We believe there is too much leverage in China, and underlying weakness with reforms failing to get started. This will be raised from time to time as a concern and, because it is the world's second-largest economy, a significant slowdown in growth would impact the rest of the world," he says.

In other parts of the world events are less dramatic. Europe is still facing an uphill struggle, although things are going better in some areas such as France and Spain. Sweden is very strong, with expected growth this year on par with last year's 4 percent.

The US is chugging along, and the big question is when and if the Federal Reserve will raise interest rates. The latest issue of the Fed's Beige Book economic report showed relatively good growth.

"We believe the Fed is prepared to act, but this depends on activity; it is watching retail trade, wage growth and employment. We believe it will act in July and raise by a quarter percentage point, with another quarter percentage point in November or December," says Magnus Nilsson.

As for Sweden, Catella's fund managers expect no change to interest rates from the Riksbank this year or early next year. What happens after that is more exciting.

"What is interesting is that the debate has begun about when to initiate a cycle of higher rates – right now investors are starting to cautiously price in a move to normalise interest rates sometime in the second quarter of next year," says Magnus Nilsson.

Yields on Swedish government securities have been virtually non-existent for a long while. Investments in these securities will remain unattractive until interest rates start to go up, but the question is how long this will take. And how much they need to move to make government securities attractive again. Magnus Nilsson does not believe investors will need to feel any urgency about this.

"I believe there are tactical plays to make in a rising market. But a real return after inflation is step one. If we start with the Riksbank's inflation target of 2 percent, and some form of real required rate of return of another 2 percent, a five-year government bond needs to be at perhaps 4 percent for it to be interesting over time. It will be a good while yet before we see these levels," he says.

So far, the Riksbank's proactive policy has not resulted in any discernible increase in inflation. According to Fredrik Tauson, most signs suggest that central banks will continue to act to boost economies, which means there are only two ways to get a reasonable return on fixed income: either by taking long maturities of government bonds and living with the interest rate risk this entails, or by being active in the corporate bond market.

"It is a worrying situation when central banks are pressing the gas pedal with no resulting increase in consumption or investment. It suggests the lack of inflation is either imported or structural, with structural unemployment lying like a wet blanket over the market and refusing to decrease," he says.

Another category of security that Catella's fund managers have recently become interested in is mortgage bonds. Alongside the volatility of August and September last year there was substantial repricing in the mortgage bond market.

"The spread between a five-year triple-A mortgage bond and a government bond went from 50-60 basis points to 100 points, and remains there. We still believe there is good value in these securities, with relatively conservative loan to value, high ratings, good liquidity and 1 percentage point more than government securities," says Magnus Nilsson.

Although most of the market has access to the same information and acts in a similar way, the market still regularly generates imperfections that make it possible for investors to act against the tide. There have been similar pricing errors this year as well, especially in the first quarter, according to Fredrik Tauson.

"This meant there were a large number of chances for the opportunist investor, when the vast majority of Nordic credit funds and high yield funds experienced outflows simultaneously. There were fairly large pricing errors in many securities, which were driven more by flows than by underlying fundamental corporate risks. In these situations we should take the opportunity to buy."

Important Information
Investments in fund units are associated with risk. Past performance is no guarantee of future returns. The money invested in a fund can increase and decrease in value and it is not certain that you will get back the full amount invested. No consideration is given to inflation. The Catella Balanserad, Catella Credit Opportunity and Catella Hedgefond funds are special funds under the Swedish Alternative Investment Fund Managers Act (SFS 2013:561) (AIFM). Catella Reavinstfond and Catella Småbolagsfond may use derivatives, and the value of the funds may vary significantly over time. The value of Catella Sverige Index may vary significantly over time. Catella Avkastningsfond may use derivatives and may have a larger proportion of the fund invested in bonds and other debt instruments issued by individual national and local authorities and within the EEA than other mutual funds, in accordance with Chapter 5, Article 8 of the Swedish Investment Funds Act (SFS 2004:46). Catella Nordic Long Short Equity and Catella Nordic Corporate Bond Flex may use derivatives and may have a greater proportion of the funds invested in bonds and other debt instruments issued by individual national and local authorities and within the EEA than other mutual funds. For more details, complete prospectuses, key investor information, and annual and half-yearly reports, please refer to our website at catella.se/fonder or phone +46 8 614 25 00.