Stockholm (HedgeNordic) – The Nordic region has been home to a solid group of fixed-income hedge funds, partly because of the proximity to the large – alpha-rich – Danish covered bond market. Two of the youngest players in this corner of the Nordic hedge fund industry are Nordic Rates Opportunity Fund II and European Rates Opportunity Fund, two relative-value hedge funds run by Nordea Asset Management’s Copenhagen-based Fixed Income and Covered Bonds team.

“We launched our Nordic Rates Opportunity Fund in 2017 because of significant demand among our clients for non-directional products driven by the low-yield environment,” says Martin Hagelskjær Nielsen, the Head of Danish Fixed Income and Euro Covered Bonds at ‎Nordea. “Investors preferred to invest in products that were not directly exposed to what happened to interest rates, as you typically see in a long-only product,” he elaborates. “They were looking for attractive alpha opportunities in fixed-income alternatives.”

“Investors preferred to invest in products that were not directly exposed to what happened to interest rates, as you typically see in a long-only product. They were looking for attractive alpha opportunities in fixed-income alternatives.”

Nordic Rates Opportunity Fund was first launched in 2017 as a closed fund for pension fund clients, with its open-ended version open for a broader investor audience – Nordic Rates Opportunity Fund II – launching in late 2019. “In June 2019, we also launched the European Rates Opportunity Fund, which focuses on the European market,” says Nielsen, who heads a team of five portfolio managers and five analysts out of Copenhagen. “We have these two fixed-income hedge funds being active in the whole investment universe we cover as an investment boutique.”

Same Process, Different Geographical Focus

Both funds seek to capture apparent deviations from no-arbitrage relationships “within the high-grade area of fixed income.” According to Nielsen, “we seek to avoid credit risk, so we predominantly invest in government bonds, covered bonds, SSAs [sovereign, supranational and agency (SSA) papers].” He goes on to emphasize that “we try very much to avoid directional exposure as much as possible. We focus on finding the best possible relative-value exposures.”

“We try very much to avoid directional exposure as much as possible. We focus on finding the best possible relative-value exposures.”

Managed by the same team, Nordic Rates Opportunity Fund II (NRO) and European Rates Opportunity Fund  (ERO) share similar investment processes focused on finding the best risk-adjusted relative-value opportunities. “This means the idea generation processes of the two funds supplement each other very well,” argues Nielsen. “However, the NRO fund will have a more focused Nordic exposure coupled with higher leverage opportunities due to the high credit quality of the Nordic Markets. The ERO fund, on the other hand, benefits from investing into a broader investment universe.”

“The NRO fund will have a more focused Nordic exposure coupled with higher leverage opportunities due to the high credit quality of the Nordic Markets. The ERO fund, on the other hand, benefits from investing into a broader investment universe.”

The Nordic-focused fund maintains a higher “covered bonds” exposure compared to the European fund. “The universe of Nordic covered bonds is among the largest and most liquid covered bond markets in Europe and will typically be an important building block in the Nordic Rates Opportunity Fund,” says Nielsen. “At the same time, Nordic covered bonds are supported by a well-functioning repo market creating an important source of funding for hedge funds.”

“In the Danish callable market, for instance, you have 2,000 different ISIN codes and a lot of complexity, as well as embedded options in callable bonds. The callable market in itself is a fantastic source of complexity alpha for hedge funds, for those players who really understand the market,” argues Nielsen. Nordea’s European Rates Fund, meanwhile, “is typically more balanced between Government and SSA risk relative to covered bond risk,” according to Nielsen. “We see it as an investment in the best possible relative-value opportunities we can find in the European investment universe.”

“The callable market in itself is a fantastic source of complexity alpha for hedge funds, for those players who really understand the market.”

“We are one of the few players covering the whole European market, from the large issues of government-guaranteed and government bonds down to the smallest covered bond issuers,” considers Nielsen. The focus on the entire European rates market provides an ample pool of relative-value opportunities for Nordea’s fixed-income hedge funds. “A quick screen of the whole European market and the local Nordic markets provides a great number of opportunities to find pricing differences.”

“We believe we have superior access to information on what is happening in the whole European fixed-income space given that we are one of the largest asset managers in this area,” says Nielsen, who heads the Danish Fixed Income & Euro Covered Bond Team that oversees more than €45 billion across various products. “This means we have a clear understanding of how to price risk premiums in all these different countries and currencies,” he adds. “We have in-house tools allowing us to compare the risk premium we get in a German Pfandbrief compared to a French covered bond, for instance, and down to the smallest Spanish and Italian covered bond issuers.”

The State of Markets

A handful of Nordic fixed-income hedge funds have been experiencing a somewhat difficult year so far. A few of them – most notably Brummer & Partners-backed Frost – were caught off guard by a rapid and unexpected flattening of the yield curve in the last week of October amid a repricing of central banks’ path of expected future policy rates. Nordea’s relative-value fixed-income hedge funds fared relatively well both in October and year-to-date.

“In our understanding, some funds have been quite aggressive betting on stable yield curves in the short end of, for instance, the Swedish yield curve,” Martin Hagelskjær Nielsen attempts to explain the heavy losses incurred by some peers in October. “We have avoided this type of exposure. Instead, we have invested in, for instance, Nordic and European covered bonds with attractive carry and roll-down in asset swap spread trades,” continues Nordea’s Head of Danish Fixed Income and Euro Covered Bonds. “Curve exposures on European government bonds have been implemented instead as more risk-mitigating trades, thereby protecting fund performance.”

“Some funds have been quite aggressive betting on stable yield curves in the short end of, for instance, the Swedish yield curve. We have avoided this type of exposure.”

Discussing the evolution of Nordic covered bond markets, Nielsen says that “we have seen nice relative performance of Norwegian covered bonds.” Swedish covered bonds have also delivered positive performance, according to Nielsen, “but heavy QE from the Riksbank have somewhat distorted this market.” The Danish callable covered bond market, on the other hand, has delivered really poor performance in 2021. “This is driven by high supply, higher rates and lower foreign demand due to less favorable FX hedging back to the U.S. dollar,” explains Nielsen.

The European Rates Opportunity Fund gained 4.6 in the first ten months of 2021, having delivered an annualized return of 8.5 since launching in mid-2019. “The ERO fund has performed better than NRO primarily due to successful allocations into EUR fixed income,” says Nielsen. “This is driven by long/short exposures on the Italian government bond curve, EUR linkers, and selected EUR covered bonds,” he continues. “The NRO has benefitted from larger relative-value exposures on Norwegian covered bonds, but has also suffered from a limited allocation into Danish callable bonds that have underperformed this year.”

This article features in HedgeNordic’s 2021 “Alternative Fixed Income” publication.