Stockholm (HedgeNordic) – Danish covered bonds enjoy a reputation as assets of high credit quality and liquidity. Despite being generally characterized as AAA-rated securities, Danish covered bonds still behave like a risky asset class with their spreads to ‘govies’ widening – sometimes significantly – in risk-off environments. This feature of the Danish and the broader Scandinavian covered bond market occasionally offers rather attractive opportunities.

Spreads in the Scandinavian covered bond market were volatile and generally widened over the course of 2022 as high and rising inflation, hawkish central banks, economic uncertainty, the war in Ukraine and other problems stirred up a toxic cocktail. Danish fixed-income boutique CABA Capital launched a fixed-income hedge fund, CABA Flex, in mid-December 2022 to exploit historically elevated and attractive spreads in the market. “The objective of CABA Flex is to utilize the current very attractive spreads through a transparent investment solution with a high expected return and a relatively low underlying risk,” says Carsten Bach, CIO of CABA Capital.

Following a few months of “calmness” and spread tightening in late 2022 and early 2023, the distress in the banking system after the forced rescue of Credit Suisse in Europe and the demise of Silicon Valley Bank in the United States has led to another wave of severe volatility and increased uncertainty. “Despite spread widening due to increased tension in the banking system in the middle of March, the fund is still trading with a positive return since inception,” says Bach.

“Despite spread widening due to increased tension in the banking system in the middle of March, the fund is still trading with a positive return since inception.”

“Importantly, the fund has performed as expected, given the spread developments,” emphasizes Bach. CABA Flex, which offers systematic exposure to structural risk premiums within the Scandinavian covered bond market – wrapped in a three-year maturity fund, is expected to generate an annualized return exceeding ten percent net of fees until its expiration in December of 2025.

What’s the Opportunity?

“Following the financial crisis in 2008, global central banks have supported the financial markets by keeping rates low and buying bonds at record scale, a phenomenon that only escalated during the corona crisis in 2020,” explains CIO Carsten Bach. This environment led to very low spreads between Scandinavian covered bonds and government bonds. “This support ended abruptly last year, as central banks turned their focus back to more “traditional” inflation fighting,” says Bach. “Ending these support programs has caused lots of volatility across financial markets, and it has also led Scandinavian covered bonds to regain their attractiveness in hedged terms (i.e. after hedging the interest rate risk).”

The Danish covered bond market generally falls into three major segments: callable bonds, fixed-rate bullets, and floaters. While spreads have become more attractive across all three segments of the market, the team at CABA Capital has focused on capturing the more attractive opportunity set in non-callable bonds. Callable bonds may offer a higher pick-up, yet borrowers in these bonds can call back these bonds in an environment of lower coupons, hence lowering the expected returns for investors.

“Within this opportunity set, the fund locks in the higher rates on the long positions relative to the short positions, thereby accruing the spread over time.”

CABA Flex seeks to capture the opportunity set with long positions in Scandinavian bullet bonds and short positions in swaps and government bonds to hedge interest rate risk. “From the outset, the fund invests in 5-year covered bonds, hedged with swaps and government bonds, on a leveraged basis,” explains Bach. “Within this opportunity set, the fund locks in the higher rates on the long positions relative to the short positions, thereby accruing the spread over time. These positions are held for three years, after which the fund is liquidated, and the money returned to investors.”

“As the fund only invests in covered bonds without optionality, and as it follows a buy-and-hold strategy, the expected return – and the path to get there – can be estimated with a much higher degree of certainty, compared to most other asset classes,” further elaborates the founder of CABA Capital. The nature of the underlying bonds and the three-year maturity wrapping of the fund creates a mean-reverting return profile over time, which means that lower returns, as seen during the market turmoil in March 2023 due to the banking crisis, will be followed by higher returns.

“As the fund only invests in covered bonds without optionality, and as it follows a buy-and-hold strategy, the expected return – and the path to get there – can be estimated with a much higher degree of certainty…”

Similar to other hedge funds investing in the Danish covered bond market, CABA Flex relies on extensive leverage to multiply expected returns from spreads. “At inception, CABA Flex had 15 times exposure, meaning that the sum of the long exposures equalled 15 times the fund’s equity,” says Bach. This level of leverage will fluctuate over time depending on the performance of the fund. “When assessing the exposure level, it is important to bear in mind that the fund utilizes risk premiums with very low levels of volatility compared to other asset classes,” says Bach.

“The expected return, until the expiration of the fund in December 2025, exceeds 10 percent per year net of fees.”

As time goes by, the bonds are getting closer and closer to maturity, resulting in a decline in the underlying risk, according to Bach. On average, the fund’s risk, as measured by the standard deviation in returns, is roughly equivalent to half of the risk in equity indices. At the same time, the expected return on CABA Flex equals the historic return on equity indices. “The expected return, until the expiration of the fund in December 2025, exceeds 10 percent per year net of fees.”

Main Risk Scenarios

Two main risk scenarios can potentially affect CABA Flex, one of which is a significant extra spread widening on five-year covered bonds at the beginning of the fund’s journey. The second risk scenario involves significantly wider spread levels on two-year covered bonds at the end of the fund’s journey. “The likelihood of a major spread widening is difficult to estimate,” acknowledges Bach.

However, if the same strategy had been employed at any point in the past 20 years and held for three years, the worst possible return outcome would have been zero percent after all fees. “Based on extensive back-testing, using 20 years of data in more than 4.000 simulations, the accumulated return (net of fees) on CABA Flex ranged between zero and 65 percent over the fund’s three-year maturity,” concludes Bach.

This article features in HedgeNordic’s Nordic Hedge Fund Industry Report.