The spread widening in the Nordic high yield market was related to sharply increased global economic uncertainty and default risk, but also to some idiosyncratic factors such as excess selling in Norway to generate cash for currency hedges and massive outflow from Swedish credit funds and the resulting temporary closure/suspension of a number of the funds. Since late March spreads have tightened but the move has lagged developments in the US and European high yield markets.
Credit spreads in the Nordic high yield market exploded in March
March was a dramatic month in the Nordic high yield market. To some extent developments in the Nordic market mirrored what we saw in other high yield markets – massive spread widening based on a sudden deterioration in and increased uncertainty concerning the global growth outlook. This is only to be expected in a situation where authorities close down large parts of economic activity in most countries and there is uncertainty about the way back to a normally functioning economy. However, a couple of special factors in the Norwegian and Swedish sub-markets, respectively, led to a larger sell-off and a slower recovery in the Nordic market than elsewhere. These will be discussed in the following.
Norway – selling pressure from tanking NOK and currency hedging
Norwegian domiciled high yield funds have mainly Norwegian clients and are normally hedged to NOK. At the same time investments in the typical fund will be 25-30% in NOK as this percentage represents the overall NOK issuance in the Nordic market (the remainder of the issuance would be mainly in SEK, EUR and USD). Under the currency hedging contract arrangements the funds and their counterparties will exchange collateral (almost exclusively cash) on a daily basis as security for movements in the market value of currency hedges. When the NOK weakens the market value of investments in SEK, EUR and USD will increase and there will be a corresponding decrease in the market value of currency hedges necessitating a cash transfer from funds to counterparties.
From the end of February to March 20 the NOK weakened by 25% against the EUR, 21% against the USD and 15% against the SEK. Moreover, the volatility of the NOK went through the roof with observed daily movements of 10% or more, e.g. between March 18 and March 19 the NOK at one point weakened by more than 13% against the EUR in less than 24 hours. These movements took place on small volumes in the NOK currency market.
NOK movements against USD, EUR and SEK (source: Bloomberg)
The unprecedented swiftness and size of the NOK weakening led to massive selling pressure in the high yield market as high yield funds in Norway had to sell large volumes to cover cash calls under currency hedging contracts. This came on top of some outflows from funds, which were also sizable but not really a big problem by themselves.
Most of the money returned in April and the positive net flow has continued in May
On March 20 the Norwegian central bank announced that they considered intervening in the currency market as they had understood the link between the volatility in the NOK and problems with the functioning of both the investment grade and high yield markets in Norway. The verbal intervention was effective in the sense that since March 20 we have seen a strengthening of the NOK and, more importantly, much lower short term volatility in the NOK. We have since learnt that the central bank did intervene in markets but only to the tune of 3.5 bn. NOK, a very small amount. We do not for a moment believe Norges Bank has any intention of trying to manage the NOK in the medium term, fundamental factors and risk perception will decide the NOK rate. But we do think the central bank has learnt an important lesson and will aim to prevent excessive short term fluctuations in the NOK as potentially the most important tool to ensure well-functioning credit markets in Norway. Thus, we do not expect to see the currency link to the high yield market to nearly the same extent in future periods of general market volatility.
Sweden – massive outflows from and closure of credit funds
In Sweden, funds did not experience the same effects from the currency link as in Norway. However, Sweden experienced massive outflows from credit funds ultimately leading 35 Swedish funds to temporarily suspend redemptions, among them some of the larger fund managers such as Spiltan, Carnegie and Danske Bank. Below is shown monthly flow in high yield/credit funds in Norway and Sweden.
High yield net fund flows Norway (source: Norwegian Fund and Asset Management Association (underlying data), DNB Markets Credit Research (further calculation)
Corporate Bond fund net flows Sweden (source: Carnegie Fixed Income research)
The difference is quite striking. In the Norwegian market there clearly was a marked outflow from funds in March but most of the money returned in April and the positive net flow has continued in May. In Sweden the outflow in March was very pronounced and money did not return in April, probably partly because there was an overhang into April of clients not able to redeem cash in March.
We believe that there are a couple of explanations for why the Norwegian high yield market turned out to be more resilient than the Swedish market during the rout in March. The first is related to the history of credit markets in Norway and Sweden. Norway has quite a long history as a credit market and also as a high yield credit market, implying that many investors have experienced up- and downturns, including the financial crisis. The Swedish domestic credit market has a shorter history, with the first domestic (SEK) credit fund set up in 2010. Most of the growth in the Swedish high yield market has come from 2015 and onwards. The second explanation we think is related to the share of institutional investors in the different markets. In Norway high yield and credit in general is very much an institutional product, the percentage share of retail investors is very low. In Sweden credit funds, including high yield has been more of a retail product, increasing the risk of massive one-way flows. We do think that the exodus from credit funds in March and the steep learning curve for Swedish credit investors has left the Swedish market more resilient in the next downturn.
The recent flow history in the Swedish market has clearly had effects on pricing in the high yield market. One example would be bonds in the real estate sector which is a particularly large sub-sector in the Swedish market. Below is shown the development of global and Nordic high yield real estate spreads.
Global and Nordic high yield real estate credit spreads (source: Bloomberg, Swedbank)
Nordic real estate spreads have tended to follow global spreads quite closely but over the past two months we have seen a clear divergence probably related to a slower recovery in the overall Swedish high yield market. Over the past few weeks we have seen activity in the Swedish market pick up
In sum, we have seen an underperformance in the Nordic high yield market relative to US or European high yield, particularly in the recovery phase after the sell-off in March. We think the underperformance is mainly related to specific features in the Norwegian and Swedish sub-markets, respectively, features that we believe have to a large extent been ameliorated. Therefore we think there are interesting opportunities in the Nordic high yield market going forward.
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