Unsettled start

Three themes have recently dominated the market:

1.  Oil prices
2.  Concerns about the European banking system
3.  Flows and liquidity in the market

We will deal with each of these themes individually.

Oil prices

For some considerable time now, the performance of all asset classes has been about more or less one thing: oil prices.
Since the start of the year, oil prices have fallen by up to 30 percent, before recovering slightly from their lows. Investors as a whole have basically ignored the fact that low oil prices offer enormous benefits to consumers and businesses. Instead, risk appetite for equities and corporate bonds has been decreasing alongside falling oil prices. The reason for the high covariance between oil prices and risk appetite may be the fear that low oil prices are linked to falling demand for oil and other commodities in general. This would, in turn, be a sign of a weaker global economy. However, there is no sign of declining demand for oil right now. On the contrary, global demand increased by around one percentage point last year, and is predicted to increase by about one percent this year as well. The graph below shows total oil demand globally.

Source: Fearney Securities

Consequently, the low oil prices are more about a greater supply of oil. In recent years, supply has been driven by increased US production (oil extracted from sand and shale), and more recently by the easing of sanctions on Iran. But because a large proportion of oil production (especially in the US) is unprofitable at current price levels, supply has recently stabilised somewhat as unprofitable production is shut down. This in itself gives a reason for oil prices to find a stabilising level. Stable oil prices make this uninteresting as an indicator of risk sentiment, thus probably breaking the link between oil prices and other asset classes.

Another reason for the historical covariance may be the risk of anticipated bankruptcies in the energy sector spreading to the banking sector through higher losses on bad debt. Some banks will certainly see increased losses on bad debt because of this, but not to the extent that it would spread to the economy as a whole. Den Norske Bank (DnB) has the largest oil exposure of the Nordic banks. Of DnB's lending, 7 percent is to the oil industry. In other words, losses on bad debt should be manageable, even for this bank.

While the banks have not yet realised their bad debt losses, investors in high-yield bonds are well on their way. Very few, if any, high-yield bonds issued in the oil sector are currently trading at their maturity value. Quite the reverse, it is not unusual for the price to be 50-70 percent below par. This means that investors as a whole have already priced in major bad debt losses in the industry. This is likely to mean that, in certain cases, they have factored in bad debt losses that are far too high. If losses on bad debt come in lower than the market believes, which will happen in a number of cases, there are naturally large price gains to be made for the selective investor.

Concerns about the European banking system

While oil prices continued to affect the market in 2015, drastically rising borrowing costs for banks are a relatively new phenomenon in 2016. As usual, it started around the Mediterranean and spread to other geographies. Deutsche Bank, in particular, has been doubted by its creditors, following two weak interim reports.
After the financial crisis, authorities and politicians decided that banks would be forced to build up their equity to improve their buffers in times of crisis. The idea was that if banks built up their capital sufficiently, then taxpayers would not have to bail them out during the next crisis. The problem has been that banks have had varying degrees of success in building up their capital. Deutsche Bank, and a number of southern European banks, are not among the most successful. Uncertainty increased when Deutsche Bank released its second consecutive weak interim report, and investors simply started to question whether the bank could meet its commitments to pay interest on its junior bank bonds (known as CoCos). As a result, the price of the bank's outstanding CoCos fell almost 30 percent in a couple of weeks. Just as with declining oil prices, these price movements were infectious. The first to be affected were other banks that had issued junior bonds - regardless of the strength of their balance sheets. The chart below shows how the CoCo values of Scandinavian banks tracked Deutsche Bank's CoCo (red) downward.

Source: Bloomberg

Now that it is suddenly possible to invest in one of Europe's most conservative banks, Svenska Handelsbanken, at prices yielding an expected annual return of 7.5 percent (on its junior bonds), you have to ask whether the infection to Scandinavian banks is really justified. Svenska Handelsbanken's capital base amounts to nearly 22 percent, compared with Deutsche Bank's 11 percent. Thanks to the Swedish Financial Supervisory Authority, Swedish banks face tougher rules and now have among the strongest banking balance sheets in Europe. Moreover, the business models of the major Swedish banks are based on branch operations, with very little investment banking and its off-balance-sheet exposure. This means much greater stability and predictability in their earnings capacity and in the risk of bad debt losses. We assert that the fall in prices for Scandinavian banks is unjustified, and currently represents a fundamental mispricing.

Flows and liquidity in the market

Inflows to credit funds have grown exponentially as traditional fixed-income investments have offered increasingly lower expected returns. This means that the liquidity risk has become more significant, in addition to credit risk and maturity risk. Most major funds in Scandinavia with large holdings of corporate bonds have a relatively similar investor base, which acts on the basis of similar behaviour patterns. Consequently, outflows come at about the same time for all funds – albeit with differing magnitude. For the funds, this means that the exit door becomes crowded as they try to realise holdings to meet customer withdrawals. The ability of the banks to absorb risk and carry individual securities in stock has been successively eroded by new regulation, which has not helped the situation.

This means that in periods of general risk aversion in credit markets, liquidity increasingly deteriorates and the spread between bid and ask prices is pulled wider apart. For a fund, this affects the valuation of underlying bonds, without there being any company-specific reasons. Outflows in turbulent markets dominated by sellers are a challenge, since the fund sells holdings at a bid price that is sometimes spread widely from the corresponding ask price. A fund with a focus on corporate bonds can counter liquidity problems mainly by holding more cash, a higher proportion of liquid bonds and good diversification. A well-diversified and solid underlying customer base and customer relationships are obviously important, so that fund flows are as predictable as possible.

In summary, we believe the corporate bond market currently offers many interesting opportunities. The prices of many individual corporate bonds have fallen unjustifiably in relation to the companies' fundamental situation. Traditional fixed-income investments offer returns that are too low, or even negative in the worst cases. Economic growth is chugging along, albeit at a leisurely pace. We regard issuers in banking, real estate and retail, as well as selective companies in Norway, as particularly attractive. However, volatility is likely to persist in the short term, which means that investment horizons need to be somewhat longer than usual. Investors with an overly short investment horizon risk taking the wrong decision and being forced to sell in panic, when liquidity is at its worst and prices are at their lowest.

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, Catella Fokus 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.