London (HedgeNordic) – In the past couple of decades and since the Global Financial Crisis, Iceland has featured in more news than it probably did in the entire century before; for good and bad. Lately the news is mainly positive with the country topping lists on best places to retire, equality and security to name a few. So perhaps alternative fixed-income opportunities should now be added to the list.

Arion Banki Institutional Asset Management spoke to HedgeNordic about their views on the Icelandic alternative credit market and opportunities that they believe exist there, both for them as home-grown investors and international ones. The asset management arm runs, among other institutional clients, the daily operations of Frjálsi, the fifth largest pension fund in Iceland, with assets of ISK238 billion as at end of 2018.

Hjörleifur Waagfjörd, head of Institutional Asset Management at Arion Banki, said fixed income investments since the first few years after the economic crisis have shifted from government bonds to alternative credit.

Ólafur Örn Jónsson, senior portfolio manager, said: “Historically government bonds have made up the largest part of pension fund fixed-income portfolios and their yields have been quite attractive. That has, however, changed in recent years and the funds have been focusing more on bonds bearing credit risk. The first non-government bond issues after the turmoil of 2008 were mainly asset-backed securities and covered-bonds because the pension funds’ appetite for senior unsecured bonds was very limited after the crisis. Spreads have since widened especially for less liquid bonds, as yields on government bonds are now historically low.”

In the last few years of low-rate environment the asset management department has begun looking at more illiquid credit such as direct loans, mortgages and investments in specialised real-estate credit funds in its search for higher yields. Bonds issued by the listed commercial real-estate companies have also provided attractive yields but with less liquidity than government bonds, he explained. “In real estate you have collateral and the credit spread between this sector and government bonds has widened, relatively speaking, with the lower government yield enabling us to capture sound credit-risk premium,” he added.

“In real estate you have collateral and the credit spread between this sector and government bonds has widened, relatively speaking, with the lower government yield enabling us to capture sound credit-risk premium.”

“Domestic banks are not as keen on lending these days because of the capital requirements imposed. Therefore there seems to be a window of opportunity at the moment where other lenders can take this role,” Jónsson said, adding that there are, however, some challenges since alternative credit generally has pre-payment risks and hence lower duration than government bonds.

Arion Institutional Asset Management has about ISK530 billion under management out of which approximately half is in fixed income. Out of that between 5% and 10% are invested internationally. Waagfjörd said investments internationally are increasing in general since the capital constraints were removed. The upper investment limit for international exposure is 50% but with currency hedging it can go over 50%.

At the end of 2018, Icelandic pension funds invested 28% of total assets internationally, according to the Icelandic Financial Services Authority, up from the lows of 20% when the capital controls were imposed. At end of 2018 the exposure was still short of the 30% allocation prior to the restrictions. Jónsson said that it is expected that pension fund investments internationally will likely rise to around 40% in the next 10 years. “In a few years, pension funds will outgrow the domestic supply which will likely result in more investments abroad,” he noted.

Total Icelandic pension fund assets at the end of 2018 were over ISK4.44 trillion which represented 158% of GDP, one of the highest ratios in the world. Jónsson also explained that the role of bonds as a return-provider has fallen significantly. Icelandic pension funds discount their liabilities at 3.5% real-rate return, whereas in reality the 10-year government bond yield is only 1%, resulting in actuarial losses for the investments of pension funds. This is expected to speed up the trend to search for yield domestically and internationally through various available instruments including alternative credit of some form.

“We are also looking at non-domestic private credit and bonds internationally but the nature of the risk profile is very different so I do not see this becoming a huge feature. In our domestic market we usually have the collateral when lending to real-estate projects whereas abroad we would in general not have the same type of collateral,” he said.

“We are also looking at non-domestic private credit and bonds internationally but the nature of the risk profile is very different so I do not see this becoming a huge feature.”

Iceland has for a long time had higher interest rates than most of the developed world but has begun cutting rates. The question is whether government bonds will continue to be in favour among institutional investors or whether they will shift to more alternative credit.

International investors looking at countries such as Iceland for their alternative fixed-income needs, have to do their homework and those buying illiquid assets in general need a big balance sheet. In addition, they need to be aware of and able to conduct very different due diligence processes compared to that undertaken for government bonds.

Before 2015-2016 when the inflow limits where introduced there were international appetite for Icelandic fixed income but in order to stop speculation the government required international investors to put half of allocated capital in 0% deposits. Since then the restrictions have been removed but appetite from foreign investors remains muted. “Investors are not selling but they are not adding either,” Jónsson said, adding that the downward traction of the interest rates might further discourage international investors.

The Icelandic bond market remains relatively shallow and the currency market slows international investors down as it is not easy to move large amounts of money, giving local players an advantage, he noted.

There may be a boost to international interest in investing in Iceland on its way with new legislation being readied in parliament for the spring 2020. While not focusing on alternative credit in its strictest sense, the Icelandic Minister of Transport has proposed legislation which would facilitate public private partnership (PPP) processes for infrastructure.

Financing transport infrastructure is at the core of the new legislation but other areas where capital is needed are energy generation and distribution, water sewage and waste systems as well as social infrastructure such as schools, prisons, elderly-care facilities and healthcare.

This is where institutional investors both domestic and international can step in. The long-term nature of infrastructure is also an excellent tool for pension funds wanting to match liabilities in an environment where investors are likely going to see rates stay lower for longer.

This article featured in HedgeNordic’s Special Report on “Alternative Fixed Income.”

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