They say that the early stages of a love affair are often the most exciting. Although Sweden has flirted with credit markets, the two have not had much of a history. But that is all changing now. Swedish investors have suddenly woken up to the ample returns on offer in the credit markets and are beginning to embrace the asset class with some excitement. At the forefront of the move into credit is SEB Wealth Management, the institutional fund management arm of Sweden’s biggest bank, SEB, and the second biggest fund manager in the country. SEB set up its first corporate bond funds in 2001 and total assets under management for the strategy have grown to around e6 billion since then.
Whilst this still only represents a small proportion of the wealth management group’s overall e120 billion in assets under management, the profile of credit as an asset class has shot up in the past year. SEB saw around e500 million of new inflows into its credit strategy in the first half of this year alone, representing around five times the average inflow volume. With client demand from its Nordic stronghold increasing all the time, the fund manager is launching its first credit hedge fund later this year, focused on the structured credit business.
The move is evidence of the development in the region’s investment philosophy, says Thomas Kristiansson, head of credit markets at SEB Wealth Management. “Swedish investors have either been buying equity or government bonds, in other words the riskiest and the safest sectors,” says Kristiansson. “They have generally avoided all that is in between, like credit. But the crisis has educated people and with prices having fallen as much as they have, credit looks attractive now. You could call it a structural shift.”
The interest in credit has gathered pace this year, not only because of the plethora of opportunities available in the sector, but also because of a move away from equity and government bonds, the traditional investment sectors in Sweden. “After the recent repricing, companies are being forced to be more cautious and they appear less equity-friendly right now,” says Kristiansson. “If the business cycle recovers then equityholders will demand their cake – but this is more for next year. On top of this people are seeing that corporate bonds are yielding around 230 basis points over government debt, whilst having low risk and volatility. The two factors make credit a good draw right now.”
Safe from subprime
The interest in credit has also been helped by the fact that Sweden was one of the few European countries to escape being mauled by the subprime and structured credit debacle. Swedish banks may have suffered large losses on their exposure to the Baltic states over the past year or so, but Swedish investors managed to avoid the riskiest parts of the structured credit market pre-2008, and few had the same levels of subprime exposure that struck down many other European institutions. Liquidity has been one key consideration in the eschewal of credit so far.
“Structured credit demand from Swedish investors was low prior to the crisis,” says Kristiansson. “If you only got 50 to 60 basis points uptick over government securities then why bother investing in this? We are into a more clean way of managing money and having risks which we can hedge. This can sometimes be difficult on the less liquid structured credit side, and is one reason why many long-only fund managers and banks avoided it.”
Of course credit market liquidity was affected towards the end of last year, but all Sweden’s key markets – including the mortgage market – remained open throughout the worst of the crisis, when others like Germany’s and Denmark’s closed down. SEB’s cause has been further helped by its use of credit default swaps, which it has been involved with for the past four years, and which helped it to maintain sufficient flexibility to get in and out of the market during the worst of the troubles.
Kristiansson says that derivatives have often showed greater liquidity and, importantly, have been cheaper to trade than the equivalent cash business during much of the last 12 months. And the ability to short a name by buying the CDS, rather than exiting the position, has been a great benefit to SEB’s portfolio management.
Still, the crisis has not passed without some negative impact for the company. SEB was overweight Lehman Brothers debt last year, and its call on the bankruptcy of the US bank could not have been more wrong. “We had discussions one week before the bankruptcy about the possibility of the US government letting Lehman Brothers go under,” says Kristiansson. “We took the wrong conclusion from the rescue of Bear Stearns earlier in the year and decided that allowing Lehman to go bankrupt would be too risky to the global economy in general. This mistake was the biggest single factor in our underperforming the benchmark index last year.”
The Lehman decision was a significant drag on SEB’s performance in 2008, leading it to underperform its Barclays Capital corporate bond benchmark index by 3.6% for the year. The fund manager was also hurt by a hasty call in buying bank debt in November, just before the second dip in the market in early 2009, which also contributed to the underperformance.
However, with the financial sector looking on a more even keel now, Kristiansson says that the fund manager has renewed its interest in bank debt. SEB currently has around 50% of its portfolio in tier 1 and tier 2 bank holdings. And the recovery in the banking industry since March has proven rewarding and been a major factor in its European investment grade fund outperforming the benchmark index by around 1% so far in 2009. Particularly attractive are English banks like HSBC and Standard Chartered, says Kristiansson, as well as French and Spanish banks, though SEB has so far avoided German financial institutions.
With such a large number of banks in its portfolio the fund manager is currently running quite a high beta exposure, with the portfolio accruing a higher yield than the benchmark. Still, Kristiansson believes that banks remain cheap from a historical point of view and thinks that the recent strong performance should continue as wider economic conditions improve. The fund manager’s portfolio is also balanced out with the inclusion of utilities and telecoms which have performed in a functional manner this year.
As well as straight investment grade corporate debt, SEB has also branched out into other more diverse credit assets of late. Kristiansson says that leveraged loans, which it went into last year, look particularly attractive relative to other assets, such as high yield bonds right now. “You have already seen high yield performing well this year, with around 40% return,” he says. “This isn’t the case with leveraged loans since many investors who had normally been buying these assets – i.e. the banks and hedge funds – have disappeared leaving a supply and demand imbalance.”
But SEB Wealth Management’s most diverse foray into the credit markets will come later this year with the opening of its first credit hedge fund which has a long/short structured credit investment mandate, and will also invest in financial debt. The move is an interesting one, considering the general lack of appetite for structured credit in Sweden. Leading the hedge fund initiative is Ulf Jacobson, head of the credit hedge division at SEB Wealth Management, who will be presiding over a three-man team.
The implementation of the hedge fund strategy was conceived some two years ago and, despite the problems in credit since 2008, it is something that SEB feels is vital to the growth of the business. Jacobson admits that there has been little focus on structured credit in the Nordic region – both on the investment and issuance front – but he believes that there are currently significant investment opportunities in the market which may prove an irresistible lure in future.
“The group’s rationale in setting up this hedge fund is that structured credit is where it sees some of the best opportunities, and where you have dramatic imbalances right now,” says Jacobson. “In general if you go back to the 1970s you will find that corporate credit has in fact given higher and more stable returns than equity from a long-only standpoint. Many investors realise that credit is maybe a more interesting asset class than in the past.”
Jacobson’s own experience with structured credit comes from having spent 10 years working in SEB Bank’s treasury division where he specialised in asset-backed securities and financial debt. His move to the wealth management division only came in March this year as the plans to set up the credit hedge fund gradually began to evolve. He says that one of the main advantages of being in a nimble absolute return strategy is the ability to play on different levels of pricing across the capital structure, as well as the key ability to go short. This kind of nimbleness may have been missing from some of the long-only credit strategies that jumped into the markets last year. “If you are bullish on credit then you go into a long-only fund, but timing is crucial,” says Jacobson. “In fact we have seen many long-only funds that were set up and have already closed down in the last year that had entered the market too early.”
Jacobson says that SEB’s hedge fund’s goal is to look for different assets across the capital structure which offer value in the current market conditions. “Lately we have seen the credit markets price in a hugely different scenario compared with other asset classes,” he says. “For example the US high yield loan market priced in a scenario where defaults were equal to the Great Depression. But this was not the case in the equity markets. It shows that markets are not always moving together, and this is something that we are focusing on.”
While the fund will only be looking to invest in senior tranches, other than this prerequisite there is no area of structured credit that Jacobson would consider out of bounds right now. He is particularly bullish on collateralised loan obligations (CLOs), where senior tranches should be able to withstand severe stress and are well priced. Similarly the European mortgage-backed securities market looks attractively cheap. “The amount of defaults priced in seems very high: for example the Spanish MBS market has priced in a lot of downside. For sure there will be price volatility, but what the loan and credit markets are pricing in with regards to default and recovery right now is very conservative.”
Jacobson is also able to bring his treasury expertise into play on the other strand of the hedge fund strategy – financials. Like Kristiansson, he is bullish on bank debt, and believes that this part of the strategy could form a good fit with the structured credit portion. “You could see how shorting financials would, in some cases, be a good hedge against a long structured credit position. A bank balance sheet, for example, would normally carry a lot of assets that you also find in CLO and MBS transactions. I think that the strategy would balance out very well and protect your downside.”
All this activity would suggest that Sweden is finally embracing the credit markets. The shift in investment mentality has been a long time coming but SEB hopes it could be the start of a long and beautiful friendship.
SEB: The story of a Swedish institution
Founded: 1856, as Stockholms Enskilda Bank
Based: Stockholm, Sweden
CEO of SEB Wealth Management: Fredrik Boheman
AUM (at June 30, 2009): SEK1,267bn (e120bn)
Euro Investment Grade fund (at Aug 7, 2009)
Portfolio return: 3.3% Absolute return: 0.9%
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