An in-depth analysis of the development in Catella Hedge and the market

When news of the corona virus started spreading around the world, for a period there was no impact on the performance of Catella Hedge. However, when the fear turned into panic in the financial markets at the end of February and beginning of March – the holdings of the fund were impacted to a large extent.

Since the first of January 2019 there was a rise in the equity market of around 45%, before a falling market initiated around 20 February 2020. Since then the equity markets lost approximately 35 percent from its recent peak, and thereafter there has been a quick rebound of around 20 percent.

Catella Hedge has the ambition to have lower risk, with a standard deviation of around 3 percent, and a return objective of 3-5 percent per annum. But in the midst of the recent turmoil, all assets were impacted and it was difficult to navigate the market. At one point Catella Hedge lost 16 percent during that volatile market.

The fixed income part of the fund had a positioning that was not suited for what would follow. The fund's high yield-portfolio, with higher yielding corporate bonds, contributed approximately with a negative 3 percent, according to portfolio manager Stefan Wigstrand. During the same period crossover, a European high yield-index based on European companies, quickly went from 200 basis points up to 750 basis points.

"It all happened with a velocity we have never seen in the past", says Stefan Wigstrand.
"We were unable to mitigate that movement in the market. Normally we have hedging positions on, but this time we came into this market with a positioning for rising interest rates. And of course, as a result, we were initially heavily impacted as risky assets sold off and interest rates sank", he continues.

Normally the portfolio managers try to hedge the high-yield-portfolio in the fund by having duration exposure, but this time that position was not on, and as a result had a negative impact on performance.

According to Stefan Wigstrand, what was most surprising was the speed of the change in the market, rather than the magnitude itself.

"The fact that crossover today is trading around 500 basis points is quite reasonable given the current situation. We have been in a situation for a long while with low levels of default. We see a normalisation – to say the least – going forward and then it is reasonable that crossover compensates for this increased risk of higher default rates. As mentioned before, it was the speed from 200 basis points to 750, that surprised the most", he says.

Part from the high yield portfolio, which contributed with a negative 3 percent, investment grade bonds were also sold off aggressively. Furthermore, the preference shares in the portfolio also sold off in a similar manner.

"We have had a share of preference shares and under normal market circumstances they behave like fixed-income instruments. Higher dividend yield but still shares. But when there is a real crisis and there is talk of cancellation of dividends, they quickly change from being fixed-income-like instruments to equity-like instruments", comments fixed-income portfolio manager Thomas Elofsson.

The preference shares quickly decreased in price. If the dividends keep coming, the return potential going forward is much higher, similar to the fixed-income portfolio. "If you think that this will calm down at some point in time and that the real estate companies can keep on paying dividends on the preference shares, then it looks quite good", says Thomas Elofsson.

The equity portfolio in Catella Hedge was also surprised by the quick escalation of events, tells Mattias Nilsson. Going into the Corona pandemic situation, the equity portfolio was quite sceptical on many shares, where valuations were deemed to be high and the potential for economic growth looked slim. As a result, the fund had positioned towards more defensive shares, that were valued quite a bit lower than the average on the equity market in general, and under normal circumstances had a lower beta than the overall market.

On the other side of the portfolio, the fund was short companies which were believed to have aggressive valuations and where expectations were high.

"In a normal cyclical slowdown, this type of positioning would perform quite well. But we have now learnt that corona is not the same as changes in the economic cycle", says Mattias Nilsson.

As examples of movements in single equity names, H&M fell 52 percent from the peak, the gym chain SATS fell 62 percent and the media company Nordic Entertainment fell 52 percent. In the case of H&M and SATS their clients couldn't get to the stores or the gyms, and in the case of Nordic Entertainment a lot of sport events were cancelled which a lot of their clients pay to see.

The defensive shares, which normally have a lower beta, got the same beta as the overall market in the downturn. An example is the mobile operator Tigo, previously known as Millicom, which fell 52 percent from the peak. This is a business which is relatively non-cyclical in nature and should be less vulnerable to the effects of Corona – as we still use our cable-TV and mobile subscriptions.

The last reason for the drawdown in the fund, that Mattias Nilsson brings up, is the issue of liquidity. The fund has owned more less liquid stocks. As investors have sold these companies there have been fewer natural buyers, and as a result these stocks have fallen more (measured in percent).

Roughly speaking, the fund lost as much on the fixed income side as on the equity side. Year to date the fund is down approximately 14 percent. The question remains if it is possible to recoup this fall, and if so – how quickly?

"On the high-yield side, which has been the most dramatic, today we have an average price of 88 percent of nominal value. Credit duration is around 3 years. If we were to receive back full nominal amount on the high yield bonds, we would get approximately 4 percent per year in recovery. To this you need to add the direct yield in the portfolio which is around 7.5 percent currently. You would hence receive a total return of 11.5 percent per annum over 3 years, given that you receive back all money invested", says Stefan Wigstrand.

It probably won't result in such a benign outcome. The corona pandemic is expected to lead to bankruptcies and defaults and for that reason it is not probable that all will be repaid. The default statistics that for a long time have been low are expected to rise.

"This time the revenues have disappeared in a manner which makes it inevitable that many companies won't be able to survive. They you need to hope that our portfolio has a better composition from that standpoint.", says Stefan Wigstrand.

To get an example what could happen you can start with the gross return of 11.5 percent and deduct what you deem are probable losses due to defaults. In a single B-segment, which is an estimate of high yield, the defaults are normally 4 per cent per year.
Then you need to note that a default does not mean all money is lost – normally you would expect a loss of around 2.4 percent per annum from the initial 4 percent, which you need to deduct from the returns in the normal outcome.

Today the situation is extreme, where some companies completely lack clients, and have close to zero revenues. Hence it is probable that some of these defaults would occur soon in time, according to the portfolio managers.

"We expect that the big problems to happen at the same time, and in the near future. If defaults would amount to 10 percent, you need to assume that 6 percent are losses", says Stefan Wigstrand.

The losses are expected to hit different sectors in different ways. Examples of sectors that have felt the problems caused by the Corona virus are the oil sector and hotels, restaurants and travel.

"We hope to have a portfolio that can manage better, which less holdings vs energy, hotels, restaurants and travel and similar", says Stefan Wigstrand. In relation to the oil sector, the fund can manage that, as it is fossil free and does not have holdings in that sector.

The performance for preference shares is according to Thomas Elofsson depending on how the crisis unfolds going forward. A majority of the preference shares are within real estate, so the development in that market is key.

"And to a larger extent than previously the real estate market is dependent on what happens in the credit market", says Thomas Elofsson and continues: "When you have developments at such a rapid speed, even policy makers are struggling to catch up.

They have lowered interest rates to close to zero everywhere and increased their asset purchases. In the US they are sending cheques to households. A lot is being done at the same time which caters for a bit optimism", he says.

In Sweden you go from a budget situation of around zero or even surplus, to 8-10 percent deficit. And if it gets worse, you can expect even more, according to Thomas Elofsson.
"Can central banks buy equities? They have proved that they are willing to a lot of things, they buy credit, and in the US they are buying high yield credit through ETFs", he adds.

Thomas Elofsson believes that the probability for a scenario where the stimulus will have positive effects is greater than the scenario which ends really badly. "The probability that you exit this in a positive way in the asset markets is greater. But of course it will take time, several years", he says.

On the equity side there is also hope to be able to recover some lost ground. The portfolio manager Mattias Nilsson sees several shares which should have good upside when the virus concerns abate. "Going into the crisis we had some companies that had unexpected negative market reactions. Companies that aren't cyclical, but still were effected by Corona. These are Nordic Entertainment, SATS, care company Ambea and satellite communication company Ovzon, even the e-commerce company Boozt which maybe has benefited marginally during the crisis", he says.

These shares have fallen a lot while a lot has not happened on the earnings side, which can create a large upside once the risk premium decreases and the uncertainty around corona decreases. On the other side there are shares which the fund is short: shares that have performed very well during the quick recovery phases. There you will find everything from grocery stores to telecom operators. According to Mattias Nilsson investors have fled to shares where the uncertainty is perceived to be lower, even if the upside is not great. Here it is possible that there is limited upside.

While the index is "only" down 20 percent since the falls started, there are shares which have fared well which there are others which have fallen a lot. Mattias Nilsson mentions the engineering companies, which they have previously been sceptical around due to economic outlook and valuations. But now when they have fallen around 25-30 per cent this could be an interesting opportunity, he says.

A big difference to earlier crisis according to Mattias Nilsson, is that the expectations outlook has changed so quickly. The car sales on the five largest European markets are now expected to fall from around 11 million down to 7.5 per year. During the financial crisis, it fell from 11.5 million to around 10 million cars. Expectations are hence low now and investors have avoided the risk.

"So if the situation normalises there is an upside of around 30-40 percent in these shares, which we haven't seen for a long time. The expectations in Europe are that this is a lost year and that the sales are down 25-30 percent for the full year, but there is a chance that it might turn out slightly better", says Mattias Nilsson. On the other hand, there are shares that are in the same world but where they have decreased only slightly: as examples Mattias Nilsson mentions Atlas Copco and Nibe. "These are fine companies, but they are not immune to neither the economic cycle nor corona. Here we find that the upside is quite limited. What has changed since the autumn is that the relative valuation difference has grown even larger", he says.

Is it reasonable to assume that there will be a focus on valuations after such an event, because isn't that what happened after the financial crisis?

"We believe that somewhere valuations will matter. What you need to respect is that you can quickly go from a situation of panic, to a new bubble caused by all the stimulus. You can can't exclude the possibility that the popular companies grow even more popular, but our thesis is that we will remain in the normal range", says Mattias Nilsson.

When you look at companies today, compared to before the crisis, have you changed anything in your selection? You could expect that manufacturing companies are impacted negatively during a period followed by pent up demand.

"Yes, absolutely. One reason that we like the industrial companies now is that they follow the global industrial production quite well. If the activity in society resumes we know that these companies will follow the trend. On the other hand in retail and hotels the situation is much more uncertain", says Mattias Nilsson.

Going into this volatile market, Catella Hedge entered with a neutral positioning between long and short equity positions. According to this has not changed, despite the big market drawdowns experienced on the Stockholm Stock exchange. Furthermore, despite the recovery that has occurred he deems the uncertainty to be high, and the most important component for the fund's equity trading is that they high volatility keeps coming down.
Right now some people are thinking about the risk of a "double-dip" – that something negative might occur after the quick recovery. Mattias Nilsson responds that the fund remains focused on what happens in the real economy.

"The volatility remains high in the market and it can easily move 3-4 percent without anything underlying really changing. We try to evaluate the data points: is it getting better or worse? That is what drives our activity and positioning