NordicInvestor contributing editor, Hamlin Lovell, hosted a roundtable discussion amongst asset managers, banks and insurance companies from the US and Sweden, covering topics including the Covid-19 crisis, policy responses and recovery; macro outlook; divergences between different credit sub-asset classes; expected return drivers; the uneven recovery in liquidity; potential liquidity mismatches in daily dealing vehicles; ESG for risk management and alpha generation, and current positioning.

Read on for a summary of the discussion or click the image below to watch the discussion on Vimeo.

Panelists; Karsten Marzoll (top left), Martin Axell (top right), Jonas Thulin (bottom left), Anand Dharan (bottom right)

Jonas Thulin, Head of Asset Management at Erik Penser Bank, in Stockholm. started teaching economics at various universities, before moving to the corporate side running a Pension Trust (Ericsson). He then moved on to London and New York working with trading strategies, and returned to Sweden to build up research and strategy at Nordea, where he ran Asset Allocation at Nordea. He “jumped ship” to Erik Penser Bank in 2017 and the firm has since grown AuM by 280%.

Karsten Marzoll is a Senior Fund Analyst within Swedish bank SEB’s Manager Research team of 6 analysts, located in Stockholm, covering 3rd party funds/managers in liquid fixed income (Investment Grade, High Yield, Unconstrained) and Equities (US, Europe, partly Sector). He has 33 years of industry experience and previously worked for SEB in Luxembourg managing discretionary mandates and fund of funds, focused on fixed income, and is originally from Germany.

Martin Axell is the Co-Head of Multi Asset at insurance company, Länsförsäkringar, in Stockholm, and is the senior portfolio manager of blended Multi-asset funds and hedge funds. Credit investing includes internal funds and external management. He has 18 years of industry experience and has previously worked in London as the head of fixed income at the UK’s second largest pension fund, the BT Pension Scheme, as an Investment Manager at Morgan Stanley and earlier as a Portfolio Manager at SEB.

Anand Dharan is Investment Director at Wellington Management, Boston, which he joined in 2015. He belongs to Wellington’s Broad Markets fixed income team, which manages multi-sector fixed income portfolios.

The Covid-19 crisis differed from the 2016, 2011, and 2008 credit bear markets in terms of its cause, the speed and coordination of policy responses and the swift V-shaped broad market recovery….

– Hamlin Lovell, Contributing Editor, NordicInvestor

Whereas the global financial crisis was caused by a global economic slowdown, the Covid-19 crisis was caused by a public health crisis. “Central bank rate rises or credit crunches did not cause this crisis. The financial system remained intact and there was not a financial crisis”, says Marzol. But central banks clearly solved the crisis at least for most investors: “the magnitude and speed of policy response was unprecedented in peacetime”, says Dharan. “The policy response was fast and well timed because the tools had been tested in 2008 and 2011”, concurs Marzol. Axell agrees: “central banks took years after 2008, but they had all of the tools ready this time, which led to a record speed of recovery”.

The policy response was also qualitatively different: “the genuine coordination of fiscal and monetary policy between Congress and the Federal Reserve – with monetary policy financing government spending – worked well and is likely to outlast the crisis”, says Dharan. Thulin was one of the first strategists who placed his faith in the policy actions: 

We have been in full on risk-taking mode since late March and have been impressed with the speed of the recovery. A V-shaped recovery was a tough call at the time, but it was based on our reading of the data….”

– Jonas Thulin, Erik Penser Bank

The base case macro outlook now is broadly bullish, though there are regional variations and risks to the central thesis.

Thulin’s contrarian call in the spring has, as of November 2020, moved towards a more consensus view on the near-term economic prospects for a continuing recovery: “we expect economic growth in 2021”, says Marzol. We are bullish because we expect a vaccine rollout, and see improving consumer confidence and spending, which will be helped by fiscal stimulus and record central bank liquidity. Economies should reopen by the second quarter of 2021 at the latest”, says Axell.

But the medium term picture may be less clear: “risks include fiscal stimulus fading by year end 2021, a European sovereign debt crisis, the ongoing trade war, and the fact that very few defaults are now priced into credit markets”, adds Axell.  Dharan’s concerns are somewhat more distant: “we are confident about 2021, but are alert to the risk of a divided US government reducing fiscal stimulus. We are also closely watching geopolitical risks and supply chain risks that could threaten the staying power of the recovery beyond 2021”.

The economic and market rebound has not been globally synchronized or evenly balanced in 2020 and is not expected to be in future.

Different countries’ governance and policy responses have already led to some variation in their recoveries. In China, companies and consumers are in expansion mode while Europe could be facing a double dip recession….” 

– Anand Dharan, Wellington Management

Thulin underscores this point: “the different policy responses have opened up huge growth and market differentials between the US and Asia, and Europe. This has dented the outlook for some asset classes and countries, especially in Sweden where headwinds are accelerating”.

Inefficiencies and mis-pricings have also varied between sub-asset classes and sectors, which strengthens the case for a dynamic and opportunistic approach to asset allocation.

Dispersion has been seen not only between continents but also within countries’ credit markets: “we expect persistent inefficiencies in credit markets partly due to the uneven policy responses and liquidity conditions: for instance, central bank asset purchases have focused on corporate credit but not as much on securitized credit. Different markets have also over or under-reacted to news-flow around Covid and policy responses, which results in mis-pricings varying between asset classes. We have used global high yield as a lever for adjusting overall credit risk, halving it between June 2020 and November 2020, and we opportunistically move between sub asset classes regularly”, says Dharan. Axell has also taken some profits on high yield this year:

We follow a global and flexible approach across regions and sub-asset classes. For example, in 2020, we first moved into investment grade credit and then high yield at spreads of 250 and 800 in April 2020 that have now halved to 100 and 400. Now these have become more expensive we expect only a tiny bit more compression and we are moving into senior secured loans, which still offer better spreads, and have very little interest rate risk, as well as emerging markets local and hard currency debt, which are geared to a global cyclical recovery….”

– Martin Axell, Länsförsäkringar

Carry is expected to be the main drivers of returns, while there is more debate over potential gains from roll down and spread tightening – and duration risk.

If spread compression has led to huge price rises since March 2020, the attribution profile may now be reverting to coupon clipping. The key drivers of return will be carry and roll down. We do not see much further scope for spread tightening in general”, says Axell. Dharan agrees that carry will be key but does see somewhat more scope for spreads to come in: currently, we see carry as the main source of returns. Additionally, central bank support, consumer and market sentiment could further tighten spreads on RMBS, EM corporates, senior secured leveraged loans, and longer dated corporates. We do not expect much from roll down because the curve is fairly flat until the long end”.

The risk and timing of interest rate rises is also contentious: “we see some risk of long end interest rate rises outweighing any spread compression for long duration US investment grade. Therefore, we own the shorter end of the curve and are underweight the long end, partly through using derivatives”, says Axell.

We recognize duration risk but our base case is that we will not see significant rate rises over the next 12 months….”

– Anand Dharan

Managers are taking active views on credit sub-sectors.

Credit sub-sectors can be compared by weighing up factors such as breakeven defaults versus forward looking defaults, price momentum, supply and demand technicals, and monetary policy. “In November 2020, our key overweight positions include leveraged loans, emerging market corporates and RMBS. We also like some emerging market sovereigns, other securitized credit, and convertible bonds”, says Dharan. We also like leveraged loans, and emerging market hard and local currency debt. We additionally like shorter duration investment grade credit. We expect cyclicals, travel such as airlines and leisure such as restaurants could outperform from spread tightening at the sector level”, says Axell. “We have less in high yield because it is only pricing in defaults of 2-3%, and there is some risk of another European sovereign debt crisis”, he adds.

We are worried about default risk in European high yield, but active managers should still be looking at CCC rated bonds….”

– Stefan Marzoll, SEB

Sector rotation could be a bigger source alpha than security selection in 2021, though the potential for active trading may be lower for some sub-asset classes.

Alpha could be added from top down asset allocation calls or bottom up instrument selection, as well as timing calls. “We expect to add 65% of alpha from asset allocation and 25-30% from sector and security selection. We are bullish on potential for sector rotation right now because we see decent dispersion. Average turnover across the approach is around 50 percent per year, but less liquid sectors with higher transaction costs, such as leveraged loans, tend to turn over more slowly”, says Dharan.

It can be more difficult to add value from active trading where bid/ask spreads are higher, but those managers we cooperate with expect continued dispersion between Covid winners and losers”, says Marzoll. Yet the name picking opportunity set might be narrower in future: “we expect it will be more difficult to generate alpha from security selection in 2021 because volatility could go down further”, says Axell. Thulin is more focused on trading in and out of sub-sectors rather than selecting either managers or individual credit securities:

We were traditionally buy and hold investors in credit, but now we are 99% tactical and 1% strategic. We have a free mandate to pick any active or passive instrument in any sector. We have exited funds and are using passive ETFs for our tactical trades….

– Jonas Thulin

The liquidity picture is mixed with some sectors having recovered to match or even surpass pre-Covid liquidity while others remain less liquid and more expensive to trade.

Active trading requires reasonable liquidity and one broad generalization is that central banks are the key players behind the liquidity recovery. This was the first crisis of this magnitude since Dodd-Frank and Basel 3 implementation, and we learned a lot about the reluctance of the sell side to make markets at precisely the time when markets needed the sell side to act as a liquidity “shock absorber”. There may need to be a larger role for central banks in the future in these kinds of market environments”, says Dharan. Marzol agrees:

now that banks cannot hold as much inventory due to Basel II, central banks are the lenders of last resort. We generally see strong liquidity in investment grade but lower rated bonds can be less liquid….”

– Karsten Marzoll

Indeed, the sectors being bought by central banks have returned to their former liquidity: “we have seen a general improvement in liquidity with US Treasuries and Agency MBS back to pre-Covid levels”, says Dharan. Axell agrees that asset purchases have been important: “central bank support for investment grade credit in most developed markets has been good for liquidity and in the Swedish market rated bonds are now on average as liquid as before. In three sub-sectors of the Swedish real estate credit market – public property, housing and logistics – liquidity is now better than pre-Corona”.

Central banks are generally not buying structured credit (beyond some triple A tranches) nor loans, and these sub-sectors are laggards in terms of liquidity: “some securitized and non-investment grade corporates that do not benefit from Fed buying are less liquid”, points out Dharan.