Stockholm (HedgeNordic) – Despite Danish mortgage bonds being widely regarded as almost risk-free, occasional spikes in risk aversion trigger significant spread widening versus government bonds. These episodes can catch off-guard the group of Nordic hedge funds heavily reliant on leverage to capture risk premiums within the Danish mortgage market. However, one Danish hedge fund has designed a strategy built upon multiple pillars to effectively navigate and capitalize on the occasional bouts of increased risk aversion in Danish and Nordic mortgage bond markets.
“We are also harvesting risk premium from Nordic and Danish mortgage bonds through leverage, although this is just one of the four pillars of our portfolio construction,” explains Torben Pedersen, the CIO of SRV Capital’s relative-value fixed-income fund SRV Fixed Income. The other pillars include the ‘roll and carry’ strategy to exploit the slope of the yield curve, the ‘raw alpha’ strategy targeting occasional market dislocations, and equally important, the ‘tail risk hedge’ strategy. The latter pillar “was also one of the main reasons why we had a positive return in 2022, a challenging period for most other fixed-income funds and the broader market,” according to Pedersen. “Through extensive analysis, we are always looking for the best positions that can protect the portfolio.”
“We are also harvesting risk premium from Nordic and Danish mortgage bonds through leverage, although this is just one of the four pillars of our portfolio construction.”
Torben Pedersen, CIO at SRV Capital
Top-Down Approach to Risk Utilization
Torben Pedersen and his team at SRV Capital adopt a top-down approach to determine risk utilization and allocation across the four strategy pillars. Their assessment of the broader market environment forms the basis for distributing risk across these pillars. “We conduct quite extensive top-down strategy analysis, and towards the end of 2021, we anticipated a period of higher inflation, higher interest rates, and consequently, higher risk premiums,” recalls Pedersen. As a result, SRV’s relative-value fixed-income fund reduced risk utilization to the leveraged mortgage bond strategy, minimized exposure towards the roll and carry strategy, and allocated more to the ‘dislocation’ and ‘tail risk hedge’ strategy pillars.
“The whole strategy framework secured a better start to 2022,” according to Pedersen, when for the first time in a decade, bond investors and market participants faced monetary policy tightening across most major markets in response to inflation concerns, further compounded by Russia’s full-scale invasion of Ukraine and the associated sanctions. “While we anticipated higher inflation and interest rates, the speed and magnitude, not necessarily the direction, was what surprised us,” acknowledges Pedersen.
Going Back in Time
During the summer and latter part of 2022, market participants observed an uptick in risk premiums driven by high inflation and interest rates. “Consequently, we slowly started to increase risk utilization in the fund to capture higher risk premiums,” recalls Pedersen. This adjustment “led to a healthy end to 2022 and a very strong start to 2023,” according to the CIO, who co-founded SRV Capital in 2018 alongside Erik Bo Hansen after lengthy careers at Nordea.
“Consequently, we slowly started to increase risk utilization in the fund to capture higher risk premiums. This led to a healthy end to 2022 and a very strong start to 2023.”
Torben Pedersen, CIO at SRV Capital
SRV Fixed Income closed 2022 in positive territory at 0.6 percent, followed by its best annual performance of 14.3 percent in 2023 since launching in early 2019. The fund has maintained its momentum into 2024, recording a solid 6.2 percent advance in the first four months of the year. The solid performance has spurred heightened investor interest and resulted in increased assets under management from both new and existing investors. As of the end of April, SRV Fixed Income is overseeing DKK 1.47 billion, up from under DKK 830 million just a year ago.
When reflecting on recent performance, Pedersen highlights 2023 as the standout year in terms of return. However, “the real challenge was actually to end 2022 in positive territory,” he emphasizes. Pedersen suggests considering both years together to grasp the effectiveness of the team’s multi-pillar strategy. “The asset allocation with lower risk utilization and higher exposure to tail risk hedges during the difficult times in 2022 secured a small but still positive return. Meanwhile, the increase in risk utilization in an environment of higher risk premiums secured the strong absolute return in 2023,” summarizes Pedersen. He also highlights the remarkably low volatility and drawdown observed in returns. “This underscores the effectiveness of our risk management in delivering not only high absolute returns but also superior risk-adjusted returns.”
“The real challenge was actually to end 2022 in positive territory.”
Torben Pedersen, CIO at SRV Capital
The fund’s strong performance in the past two years reflects its flexibility in adjusting risk utilization across more risk-on, and risk-on strategy pillars, but also reflects the proactive approach to capturing investment opportunities across different regions. “The allocation towards leveraged mortgage bonds was significantly higher going into 2023,” says Pedersen. “Moreover, we also actively managed the allocation between the Danish, Swedish, and Norwegian markets to get the best risk-adjusted return from the allocation,” he elaborates. “We are quite active in the allocation between different currencies and different maturities, trying to find the right part and spot on the curve.”
Expectations
After achieving a 14.3 percent gain in 2023 and an additional 6.2 percent in the first four months of 2024, partly attributed to narrowing spreads, the team behind SRV Fixed Income remains optimistic about prevailing risk premia levels. “We still see risk premia at fairly attractive levels, but also observe a lot of opportunities arise, especially in an environment characterized by falling inflation, and potentially lower rates from central banks across Europe at least,” argues SRV Capital’s CEO and co-founder, Erik Bo Hansen. “For our strategy, this is a very attractive environment for us to maneuver in.”
“For our strategy, this is a very attractive environment for us to maneuver in.”
Erik Bo Hansen, CEO at SRV Capital.
Though the team refrains from making speculative forecasts, Hansen asserts, “If we were to look into a crystal ball, we anticipate very attractive returns for our strategy at least throughout the remainder of 2024 and the whole of 2025.” Anticipating a normalization of interest rates by European and Nordic central banks, Hansen and Pedersen express optimism and hope that “we will not go back to negative rates.” Pedersen argues that this “is a lot more healthy market and scenario that we are looking at, which is much more positive for investors as well.”
