With the 30-year bond bull market having come to an end, return prospects for bonds look bleak for the coming years. While EIE data overwhelmingly show evidence of the long-expected ‘Great Rotation’ from bonds to equities, Claes Roepstorff, head of balanced and alternative products at Nordea Bank in Copenhagen, points out that many retail investors are still sticking to bonds.
“Risk avoidance is almost in the DNA of our clients. The change in sentiment we have seen among professional investors seems not to be shared by retail investors”, he says. “Money keeps pouring into our multi-asset balanced funds. Last year we saw total net inflows of approximately €3bn [compared with a total AUM of €30bn], especially in the two funds that have the highest weighting in bonds.”
Heading the department of balanced and alternative products, Roepstorff is responsible for designing multi-asset products for retail and private banking customers. He also leads the team that composes the investment portfolios of Nordea’s multi-asset products.
Bound by risk profiles
Roepstorff emphasises that the conservative inclination of most of his clients limits his investment team in adjusting the weightings within multi-asset funds. “We have slightly adjusted the benchmarks of our funds but the changes we made have just been minor. We have, for example, reduced our holdings in government bonds slightly, and started to invest more in investment grade corporate bonds and emerging market debt, though we are still not overweight in the latter.”
“Our clients remain tied to their risk profile and our multi-asset solutions need to meet both a minimum return target and maximum amount of losses clients are willing to accept. As clients are not prone to adjusting these risk profiles, they tend not to switch to riskier products either.”
But considering today’s record-low central bank interest rates, investing in bonds is likely to generate poor returns in both the short and medium term. So what strategies do Roepstorff and his team deploy to jack up the returns of especially the two most conservative funds?
“It’s true government bond yields are compressed, which makes it more difficult to generate a good return on these investments”, he says. “So it is essential to look for other sources. So as not to compromise the risk profile, we deploy anti-beta and long-short strategies in the equity part.”
These strategies would enable Roepstorff’s team to increase the weighting in equities slightly at the expense of bonds. “But in the short term, we are holding back with our equity investments because of the unstable risk on/risk off climate,” he says. “Although valuations are not as attractive as a while ago, the climate for equities is still favourable. We are especially optimistic on emerging market equities. For example, in China the fundamentals still look good.”
A safe bet?
Still, considering Roepstorff’s team has to invest by far the largest chunk of entrusted money in bonds, generating a decent return looks like a difficult task. However, the Danes have got a secret weapon: mortgage bonds. Danish house buyers collectively issue bonds to finance their homes. Thereafter, the bank that has bought these bonds sells them on the secondary market.
“The Danish mortgage bond market has a size of DKK230bn (€308bn) and has a liquid secondary market. On top of that, the payback ratio is more than 99%. Therefore, Danish mortgage bonds constitute a good – and higher yielding – substitute for government bonds,” Roepstorff explains.
The Nykredit Mortgage Bond Index, which encompasses a portfolio of the most liquid Danish mortgage bonds listed on the Copenhagen Stock Exchange, made a return of 30% since February 2009, while 10-year US Treasuries made a loss of 1.8% dur-ing that same period.
“In Denmark it would be silly not to invest in mortgage bonds. It’s an enormous market – exceeding Danish GDP – and during the financial crisis it showed resilience. As a consequence, Danish households’ economies are highly leveraged, but because they can only issue bonds for up to 80% of the value of their properties, the default ratio is extremely low.”
Nordea’s most conservative Danish multi-asset fund, Nordea Invest Basis 1, has half of its assets under management invested in Danish mortgage bonds. On a one-year basis, it made a return of 5.15%, more than twice the return of its aggregated benchmark. Considering the positive returns on mortgage bonds over the past few years, the relatively high interest rate compared to government bonds and the AAA rating most mortgage bonds enjoy, investing in Danish mortgage bonds looks like a no-brainer.
A bleak horizon
But danger is looming: the IMF warned in a report that Danish households’ high debts and ‘nega¬tive liquid assets’ might lead to default and loss rates on Danish mortgage bonds going up.
More serious is the threat from the European Banking Authority. It proposed last autumn that Danish mortgage bonds should not count as first-class liquid assets, like government bonds, and that mortgage bond holdings be limited to a maximum of 40% of liquid assets. While all of this threatens the long-term love affair of Roepstorff’s investors with fixed income, it will probably be a long time before the circumstances are extreme enough to change their DNA.