Meet the manager: Kim Mikkelsen, Nordic Asset Management

 
         Kim Mikkelsen


Nordic Asset Management is seven years old almost in May. We only focus on fixed income products – we have four fixed income funds as well as long only funds. Currently assets under management is around 450 million euros. The main strategy is that we focus on relative value within the Nordic bond market especially the Nordic mortgage markets. We have ten employees and the reason we have so few is we outsource our administration.

Can you explain your investment strategy?

Three of the funds focus on Swedish and Danish bonds. We operate relative value strategies within the mortgage bond market i.e. playing the option-adjusted spreads between two different mortgage bonds as well as playing option-adjusted spreads versus swap markets, versus government markets and also currency spreads within Scandinavia.

All of the funds tend to have very little directional risk and only focus on spread risk. All the mortgage bonds in Scandinavia are triple A rated mortgages so it is a super high quality credit approach. Rather than being just a long credit type of fund, we are both long and short credit, and depending on the market view of where credit spreads would go in the country and the area then we can be both long and short credit. It has nothing to do with the credit risk we have seen in the big world blowing out because this is triple A rated low long-term value type mortgages that are listed on the stock exchange, that is traded every day and has two big prices on it. It’s much closer to a government security.

We have different degrees of leverage. The Asgard Fund, which was the first one we launched, is entirely focussed on the short end of the yield curve, which can go up to thirty times leverage. It typically only engages in buying asset swap spreads from 0 - 3 in the yield curve and playing differentials between the mortgage finance as a secure asset versus us receiving unsecure floating rate note. At the moment due to the credit crisis the spread is up to 40, 50 bases points between secure and unsecure funding, where we as the holder of the mortgage get the secure funding and on the swap contract we receive the unsecure funding. We receive 40,50 bases points and if we leverage that 20,30 times we end up with a double digit return after fee.

The AAAsgard Fund can be totally borrowed yield curve and can also go to thirty times leverage. We operate a relative value approach on primarily Danish mortgages, and secondly Swedish mortgages where we simply buy and sell the option adjusted spreads. If we think option adjusted spreads are coming in will we can go long mortgages, if we think it is going out we can go short mortgages. If we have intra – especially in Denmark because the market is very big we can have different coupons or spreads, or we can have different sectors of the market that we are long/short.

The Nordic Leveraged Bond Fund is long on Danish mortgage bonds. We have a managed account with a bank which can go up to twenty times leverage. In general because the Nordic mortgages are tier one collateral with the central banks and are very easy to fund and finance, we can go to a higher leveraged degree than possible if you are trading in investment grades or credit bonds in Euros or the US. The volatility on the spreads also tends to be lower in Scandinavia than the rest of the world. We try to finance that it in either Euros, Swiss francs or similar low yielding currencies. The fund is long mortgages but it is leveraged three, four or five times.

And last but not least we have a standard long only product which focuses in its fee structure on absolute return. We have a ‘no cure no pay’ policy for clients that have long only assets with us. They don’t pay an admin fee or a running fee. They just pay a 10% performance fee for a performance over a benchmark. Any client coming in can say, for example ‘ok here’s a billion dollars to run – this is the duration, these are the areas’, then every performance we deliver over the risk free rate we charge a 10% performance fee rather than most other long only mandates in the world which are still relative performance.

Some clients will want us to only invest in all of Scandinavia, others want only Denmark, some all of Europe. The general concept is that it’s a ‘no cure no pay’. So if we cannot provide a performance that’s over the risk free rate we don’t charge anything. We launched it late last year and we’ve already raised 135m euros. The target is to raise 1 – 1.5 bn euros in long only assets. It’s a good diversifier for the company to be focussed on the long only assets, and also since the hedge fund sometimes goes short on different parts of different maturities the two products can offset each other sometimes.

What kind of investors have you attracted?

When we started five or six years ago with the fixed income area we tended to attract private banks from abroad, wealthy Danes and Scandinavians living abroad. Once the company had a three-year track record we started to attract more institutional investors, pension funds, banks, treasury offices in Scandinavia. We have very little from fund of funds – only about 5m or 3m euros. A lot of hedge funds are doing poorly at the moment and that is causing fund of funds to reduce their positions with other managers but we won’t be affected by this trend, because we don’t have the exposure.

The original thinking behind the company was that Danish mortgages had a very bad reputation around ten years ago when LTCM went down and Danish mortgages were believed to be one of the strategies they lost money on. Therefore a lot of fund of funds, especially the ones that don’t have specialist knowledge about fixed income, tend to shy away from mortgages, especially Danish mortgages where they have no natural understanding of the product. So we have to concentrate on building up other types of clients.

In addition, we have not had a very aggressive marketing approach to clients so we’ve tended to deliver the results and get known and clients have come from within the existing network of the original three partners. Up until a year and a half ago we still only had $60m assets under management – now we have $440m – but as we get more known people say ‘hang on what they are doing is working quite well, and they are adding value in a different way than many other mortgage related funds.’ The standard mortgage fund if you look abroad tends to be always long mortgages but we both go long and short.

Do you think what you do means you stand out from other fixed income funds?

We are more like a relative value fixed income fund who are active in a specific niche area in the Nordic markets. Since all the managers are Nordic it makes sense for us to have an expertise and stay with that expertise we have. We are one of the few that is doing what we are doing so we tend to be recognised as experts in the area, but also as a Danish fund if people want exposure to that area we are very hard to avoid.

On the other hand because we are in a niche area there is a limitation to how much money we can run. Unlike, for example London-based, US-based hedge funds, we can’t grow exponentially in the market. A typical amount of capital we can run per strategy is between $100m and $200m. Some areas a little more, some a little bit less. When we look at other relative value strategies what we are looking at is thirty times leverage product – well, $200m is a cap.

Do you have any opinions generally about other European fixed income funds in the current climate?

In general the impression I have is that the ordinary fixed income funds have actually performed quite well. Most fixed income funds tend to be very good at adjusting. Even if we get a blow-up from somewhere that could be a massive move on the yield curve or a spread widening because fixed income funds are typically active and fairly liquid instruments they tend to be able to adjust fairly quickly. They have a bad month yes but then they adjust to a new trading style and a new market.

A lot of the fixed income traders tend to have a long track record in both the long and short markets and being able to trade yield curve spreads and credit spreads Obviously there are credit funds in Europe that are suffering at the moment. But we are only talking about a few that maybe were highly leveraged in the lower end of the credit spectrum who have been investing to gain carry. People tend to focus on the funds that are losing money now but if we look historically many of the European credit funds had three or four good years and then get one bad. That’s kind of the cycle if you invest in credit funds. They tend to be net long. It’s almost like a long short equity fund. When rates come down and credit spreads go in they make money every year and in the fourth or fifth year when they go the other way they tend to lose money. But I think that most European managers seem to get along with this troublesome market very well.

Last year Standard and Poor’s issued a warning about investing in fixed income funds but that was directed at retail investors. Do you think this picks up on your point about fund of funds avoiding fixed income and not necessarily understanding fixed income?

I wouldn’t have a clue why Standard and Poor’s would set themselves up as an expert on investing in fixed income funds. What is important to understand is that Standard and Poor’s is a rating agency. What they tend to do is rate different bond numbers especially in the US and obviously since there is a lot of sub-prime mortgages that has been downgraded by Moody’s and Standard and Poor’s you can argue that that market could be troublesome when it comes to clients but I don’t think you can compare that to the European context. The Danish mortgage bond system has never had a default. Neither has the Swedish. They will not have a default even if house prices go down 30%. The great thing about a crisis in the US is that the scare pushes the spreads in Scandinavia wider and creates extra buying opportunities for funds like us.

What trends do you predict generally in the financial markets?

The biggest trend I see, which I think that most people in the world now agree on, is that the housing tumble in the US is going to create low growth in the US. There is still something about the saying if the US sneezes someone else catches a cold. Growth generally in the western part of the world will slowdown and if you look at it historically a slower growth means government budgets are usually doing worse than they were doing the previous year.

Right now because we are in the middle of a crisis, government bonds are trading very expensively because of flight to quality. Over the next two to three years there will be an increase in the number of government bonds issued to finance worse budgets because of lower growth. If you look at the US they have had to put out one after the other support packages in the last couple of years, which obviously means they will have to print more government bonds.

The US has spent a lot of money on the war now they have to spend a lot on getting their domestic system up and running. If you have a fiscal lax policy in the US and growth is going down over there you’ll probably have to have a slowdown, historically less than previously but higher unemployment and in Europe. The housing markets around the world looks a bit gloomy as well so if we have a sideways maybe even a slightly falling housing market the demand for housing loans will be at their low for the next two or three years. After five to ten years of increasing demand for housing loans they will suddenly go the other way.

There could have a situation where everybody is selling mortgage loans off because they are afraid of them and especially in Europe you’ll see the loan demand on mortgages will remain low for the next couple of years. Government bonds insurance will increase and thereby government bonds will go from being really expensive as they are currently to become much cheaper, while mortgage debt in a couple of years will be probably be more expensive. People are realising that triple A credits are very good and should not trade at a 100 bases points over a government bond. That’s unheard of.

Analysts have suggested that alternative assets investors will be investing less in equities and fixed income in the future. What do you think?

It’s hard to say because there’s no doubt that alternatives have a good place in any portfolio as a diversifier. Now to advise retail clients to invest in hedge funds and put all their money there would be horribly wrong. If you look at the long history, even though it’s difficult to get in hedge funds, hedge funds have worked as good diversifiers as well as people saying well, commodities can work as a good diversifier in the portfolio. Well you shouldn’t put all your money in commodities and you shouldn’t put all your money in hedge funds.

There’s still plenty of room in a portfolio for equities. What you can argue is that with the current level of interest rates in government bonds – we are talking about US ten year government bonds yearly of between 3 and 4.5%. If you’re an external, not an internal domestic investor, - who will buy US government bonds at 3.5 or even 4% when the dollar is seen to be going down every day? One year annual returns have been washed out in one month with falls in the dollar.

One casualty for these alternative investments would be a reduction of government bonds. I think that a lot of clients have too many government bonds already, because it’s only three years ago that we had a totally different discussion in Europe. The question posed then was: are pension funds chasing yield because they are under regulatory pressure to actually match asset and liabilities? The pressure then was on to buy long-only bonds both government and credits to get as much duration. What they are facing right now is the same situation as when equities were at their low in 2002 and early 2003. Then pension funds went out of equities into bonds to cover their liabilities then four or five years later when the equities were at their high they sold all their government bonds and bought equities and now the thing is turning around again.

I think generally that with regard to government bond yields with a free handle anywhere in the world that it will mean an unacceptable investment when inflation in most of the places in Europe is holding at the same pace. You can argue for safety reasons that investing in a 3.25% yield in a three year government bonds in Europe when things are looking gloomy and insecure can be a safe haven. But a ten year government bond in Europe has yielded less than 4% when the latest inflation figures from ECB are 3.2%, I don’t think a year yield is less than 1%.

For my money I would not be invested in bonds, I would be invested in equities. You’re buying something that’s been thrown out, banks are half their value in some places of the world. Royal Bank of Scotland in the UK was half the value it was nine months ago. They had a dividend yield of 7% after trading at a price of 5%. Unless they go bankrupt it’s unheard of the levels they are trading at right now. If the alternative is a ten-year government bond with a real yield of 1% then I think I’ll invest in equities. So I wouldn’t be surprised if there isn’t an ongoing exit within the family offices out of fixed income into alternatives, into equities for a mixed bag of alternatives.

The problem is obviously the pension funds have to be in fixed income because the regulatory environment says you still have to match assets and liabilities. Therefore they use a discount yield curve, which is based on the bond market. You get these stressed situations where bond yields come down and equity yields go up i.e. equities going down means they will be forced into not creating a big pension hole. They’ll be forced into fixed income and other equities at the worst possible time.

There were some numbers out in the UK regarding the pension deficit and for the first time last summer when equities were at their high and bond yields were pretty high in the UK and Europe. That was the first time in many years that pensions had a surplus net. Ever since rates have come down by 1.5%, equities down by 20% - 30% - and the pension hole is back. People are restrained in investing and that’s also driving what we are seeing right now.

Analysts have also highlighted that the days of high leverage deals could be over. What are the implications for hedge funds?

It’s very important to identify what sector you are talking about when you discuss leverage. There is a very big difference between the hedge fund industry and for example, the private equity industry where there were leveraged buy-outs. If you take for instance a company like Boots, in a leveraged buy-out another company buys Boots and they borrow 90% of the purchase price and then tries to sell those high leveraged bonds out in the market. Even though they get a very high yield on them, Boots doesn’t have to lose much money one year without very quickly being unable to pay, and go into bankruptcy. Even five to ten times leverage in that type of bonds can be very difficult.

I’m sure that a lot of people within that industry have learnt that lesson over the last twelve months. If you then move the other end of the spectrum and look at for example triple A rated mortgage bonds or triple A rated corporate bonds, then I don’t see a problem of leverage in that area. I think it’s very important to distinguish the underlying asset and look at the potential volatility of the underlying asset even in a crisis situation.

The problems we have now in the financial markets stemmed from both lax lending and to less restricted views on markets when equity markets were at their highest.  Banks and insurance companies didn’t really distinguish on whether it was a two year long bond with a very high graded credit rating or a fifteen year long bond with a low credit rating. Everything could be leveraged. It was an ongoing machine, everything seemed to be going well so they just kept printing tickets and making money. For the investment banks it was just a question of how much could they leverage into structured vehicles, sell off in a new package and there was no quality control along the way. Now we have to unwind a lot of these things and the whole system goes into reverse for a while.

But if you look at the performance historically during all this enormous credit tightening there wasn’t a massive credit tightening in Scandinavia among triple A rated bonds. And therefore there hasn’t been a massive credit widening on the way out again. Scandinavian countries are more mean reverting. Sweden is suffering because it’s a very liquid market and has been a very attractive market for hedge funds to buy in and buy out of. But in the Danish mortgage market the amount of foreigners involved in that market is down significantly from both five years ago and ten years ago. When foreign ownership is very low it is a sign that the domestic pension funds is saying ‘ok is this actually an attractive yield level to invest?’ One of the problems is that yields are actually down. So they aren’t jumping the gun to actually invest at the moment because the bonds are up – they are just not up more than a third of what other bonds are up.

The actual level of leverage I wouldn’t worry too much about in Scandinavia. I’m more concerned about triple B rated corporate bonds. There it is very possible to talk about potential never reaching the same leverage again. Some of the private equity funds have seen that unlisted bonds have no market price on and that can be very difficult to sell off.

On the other hand we all know that Warren Buffet is standing with a big war chest of money that he’s not afraid of investing when premium goes high. When everybody else goes running onto the train he’s been saying ‘this is ridiculous I’m just piling cash’. Now everybody wants to get out he’s sitting on a very big pile of cash and can actually invest at the right time. When he comes out and says look I’m going to offer these monoliners a deal – that means we’ve reached evels that are very attractive. It’s just a matter of time before we see a normalisation and it take nine months, it can take eighteen months but we will see a normalisation again and go back to more medium levels on good credits. I don’t foresee bad credits performing whatsoever. I think the market has learned now that there needs to be a risk premium on bad credit.