The $1.23 trillion Norwegian sovereign wealth fund celebrates 25 years of investing in fixed income. Sarah Rundell looks at some of the highs and lows of its fixed income portfolio which makes up around 30 per cent of fund.
What began as a tiny NOK2 billion ($0.23 billion) allocation spun out of the Norwegian Central Bank’s management of foreign exchange reserves 25 years ago invested mostly in liquid, short duration German Bunds, has grown into a global NOK2,925 billion ($334 billion) portfolio. Still, the task of fixed income in Norway’s giant sovereign wealth fund remains the same: reduce return fluctuations, meet liquidity needs and reap bond market risk premiums.
The allocation (currently around 30 per cent of the entire $1.37 trillion portfolio) has weathered the financial crisis and the European sovereign debt crisis, negative rates and exceptional monetary policy that has helped create a current environment of risk reward very much skewed to risk.
In a recent paper, asset manager Norges Bank Investment Management’s (NBIM) fixed income team reflects on a dynamic, active strategy over an extraordinary two decades that has come to fruition with its most stellar results in the last five years. Between 2016 to 2020 the relative performance for internal fixed-income management was 45 billion kroner ($5.1 billion), the most successful period for the allocation in the history of the fund. Returns since inception are around 86 billion kroner ($9.8 billion)
Steep learning curve
Today’s success is a culmination of years of hard-won experience. Up until the end of 1997, the fund was managed in line with Norway’s long-term foreign exchange reserves with the bulk invested in European government bonds: active management of currency and interest rate risk was deemed inappropriate for a central bank and index management was front and centre. By the time the fund’s current head of global fixed income, Asgeir Haugland, joined NBIM in autumn 2002 as an assistant portfolio manager, strategy had evolved to a handful of independent portfolio managers running enhanced indexing strategies in search of alpha with an absolute return focus. They were part of a front office made up of around 20 people he recalls, speaking in a webinar accompanying the report.
A strategy and team ill prepared for the turmoil lying in wait.
“The losses in 2007 and 2008 were unforeseen” says Haugland who describes “hard” and “long days” at the peak of the GFC. Advanced indexing strategies suddenly began to correlate with the wider market bringing large performance swings and uncertainty.
“During the financial crisis we discovered common factors to much of our risk taking. There was nowhere to hide,” he says, adding that hitherto reliance on tracking errors and historical correlations “wasn’t enough.”
Come 2009 NBIM had begun to sell down its fixed income allocation, purchasing equities at attractive valuations and ending fixed income’s reign as the largest asset class in the portfolio. Strategy shifted to reducing the use of leverage and the fund recovered mark to-market losses from legacy assets. The allocation was in better shape to capture opportunities in the next crisis: turmoil in European sovereign debt.
The GFC triggered other key strategy shifts over the ensuing years. Since 2002 the role of external managers had grown as the fund outsourced strategic exposure to mortgage-backed securities in the US. Poor manager performance going into and during the GFC led to external management being phased out.
“We realised that external mandates also required internal management of that same segment; we needed the capacity to take assets back home if necessary,” says Haugland.
The fund’s growing internal focus got another boost in the next, seismic shift. NBIM set up a fixed income trading operation, creating a new division of labour that allowed portfolio managers to focus on long-term portfolio construction and traders on short-term timing and sourcing liquidity in the market.
Cue the start of a trading prowess that proved its worth during 2020 COVID induced market turmoil when even US Treasuries, the bedrock of the global financial system, became illiquid and difficult to trade. The most hectic period of turnover in the history of the fixed income allocation was underway as the government began to finance its fiscal response to Covid-19. Elsewhere, market dislocations provided relative value opportunities while governments’ scramble for liquidity and huge issuance programmes added to the largesse: offering issuers liquidity by purchasing new bonds in syndication processes was an attractive investment strategy, especially in the Euro area.
Today NBIM’s team comprises 25 portfolio managers, 10 analysts and 15 traders across different time zones invested across geographies, currencies, sectors and types of issuers – all overseen by specialist teams including increasingly expert trading and credit analysis. A uniform incentive structure is based on the portfolio performance achieved by the entire team with team members with less responsibility specifically encouraged to voice their opinions and challenge views and market outlooks to avoid groupthink.
Looking to the future, Haugland believes the segmented nature of fixed income will continue to offer opportunities for NBIM’s active specialists, doing something different to the other big fixed income players. Central Banks remain the most dominant, buying bonds in line with monetary policy rather than any risk reward analysis. Elsewhere, large passive fixed income investors plus those seeking to match their liabilities dominate.
“There are opportunities for us because we are more active and we know how these passive fund managers work,” he concludes.