What do you do when interest rates rise?

The chosen debt instruments have one particular characteristic, a high coupon. Furthermore the fund has not been the victim of any defaults this year, which has led to a robust portfolio. The fund consists of five different asset classes, or “buckets” as they call them. In order, these are cash, investment grade, high yield, a class called opportunistic high yield and the final bucket, called overlay. This one is largely about stabilising the return on the portfolio.

During the year, the managers’ assessment has been that central banks would remain expansive and key interest rates would remain low.

“Even though the Fed is starting to backtrack and there will probably be signals from the ECB of more reductions in its asset purchases, quite a lot will have to happen before policy rates are upped in Europe and Sweden next year. There may be a hike, but it is difficult to imagine this happening until the purchases have ended,” says Thomas Elofsson.

What about these different buckets? The first is cash. Pure liquidity, but surely not in a bank account as these give negative returns?

“Obviously if you have a lot of high yield which, as you know, cannot be traded, then you need to offset this with something highly liquid. The way it has been designed this year is that we have had a large amount of cash. This is partly on deposit, but also in triple-A government bonds and housing bonds. You could sell this portfolio in minutes if you needed to,” says Thomas Elofsson.

The individual risks taken in high yield are offset with a large amount of cash and cash-like investments, at around 25-30 percent or even a little higher. This is a pattern that applies to all portfolios.

Stefan Wigstrand points out the importance of being agile, being able to handle withdrawals and also being able to act if something interesting turns up.

“You should probably expect us to hold a large proportion of high yield investments that are illiquid by definition, and especially in a bear market,” says Thomas. “This means we have to hold a large proportion of cash and cash-like paper.”

Then there is an investment grade bucket, which is fairly empty at the moment?

“Our reasoning is that we can get a return of 3 or 4 percent on a fairly decent high yield bond. If we compare this with perhaps one-tenth of that return on an investment grade bond in a fine Swedish industrial company, then it is not worth the risk,” says Thomas Elofsson.

Is it even the case that you see a greater risk in investment grade if the market is really bad?

“No, high yield is where the greatest risk is found. Partly in the underlying companies, of course, but also in the way the market works. It is a much smaller part of the market. If times get tough, high yield will be hardest hit,” says Stefan Wigstrand, while Thomas Elofsson expands on this reasoning.

“Imagine having two choices: the first is investment grade, and the second is putting together a portfolio of what we refer to as liquidity – like government bonds – and high yield. You then calibrate them so you think the level of returns is about the same, and at that point we believe there is a much lower level of risk in having government bonds and high yield rather than having investment grade.”

Let’s instead look at the high yield bucket, where you have currently chosen to place quite a lot of the capital. What types of company and returns does it have?

“It is getting tougher and tougher to identify relevant returns given that the market has strengthened like it has. We hope to be able to contribute by creating a slightly different portfolio than the market can generally offer. We look closely at the Nordic region, at Nordic issues. It is not unusual to get a better payback here than in the rest of Europe,” says Stefan Wigstrand, while emphasising the slightly “different” deals the fund has made.

“In the financial sector, we have chosen debt collection companies over traditional banks. We regard them as relatively easy to analyse, and compared with banks the business is a lot more predictable. The payback is better as they are not as well-known. We have played this industry fairly intensely this year, and the Lindorff deal gave the entire sector an upswing in valuation, which also benefitted us on the debt side.”

The big sectors in Sweden are real estate and banking, where you do not have much invested?

“We have no banks, but we do have some real estate. In these investments we try to find bonds that have collateral associated with the debt, known as covered bonds,” says Stefan Wigstrand.

What are the levels like?

“That depends entirely on the type of project, but we have probably managed to create investments that are around 5-6 percent on different property loans.” 

In addition to protecting the portfolio through diversification you also use derivatives, even in the stock market?

“For much of this year we have had put options in the stock market in the Catella Credit Opportunity fund and in the fixed income component of Catella Hedgefond. We have felt comfortable with the economy and with high yield as an asset class – but the big threat to all corporate risk is a significantly weaker economy. This would cause the stock market to fall quite substantially, and owning put options in the stock market is a way to be able to manage that risk,” says Thomas Elofsson.

Spreads have narrowed, and this is one reason why corporate bonds have been attractive. Now that they are at about the same levels as in 2007, do you see a risk of spreads widening?

“There is always that risk. We measure interest rate risk as duration, and we can measure spread risk with spread duration. The more duration you have, the more sensitive you are to these movements. What we have done is to reduce credit risk in that way, by having lower spread duration, in other words shorter debt maturities. This is a result of our belief that spreads are very low,” says Thomas Elofsson, and provides an example calculation. “I have done a quick calculation for our portfolio, and if spreads were to widen by 30 basis points, meaning 0.3 percent, the effect would be more or less equivalent to what we are able to gain in running yield over a quarter.”

Fed chief Janet Yellen has made four interest rate hikes since 2015 and is warnings of another three next year. Will policy rates continue to rise?

“These are fairly good times for the economy as a whole, and the US is a little ahead of us. They have decided to reduce their balance sheet and will continue to raise interest rates. If we look at Europe, we see that the ECB is buying securities and bonds in the market, but it is very likely to signal a reduction in October. I believe the ECB will continue to buy some securities into next year, which makes it very difficult to imagine the bank starting the raise rates here. The market may be pricing in too few hikes in the US next year, and too many in Europe and Sweden,” says Thomas Elofsson.

The Fed's balance sheet was somewhere around USD 850 billion before the 2007 financial crisis. At present it could be somewhere around USD 4,500 billion instead.

“In some ways it is quite unreasonable to be doing this in the US and Sweden since times are not that good. At the same time, you have the problem of inflation being so low. If we need to watch any data, it’s inflation. And the rate of inflation in Sweden has risen a little,” says Thomas Elofsson.

In summary, record-low market interest rates make it virtually impossible to achieve historical yield requirements with traditional fixed income savings in money market funds and bond funds. Catella Credit Opportunity is one of the few funds in the market with a mandate that makes it possible to handle a market with rising interest rates.