34 CFA members and candidates had signed up to hear Kjennerud and DNB Markets' analysis of how the bond market collapsed during the global lockdown in March 2020, causing record high spreads and hurting companies in need of financing.
"The entire market dried up within a few weeks. Not just the high yield market, but the entire bond market froze», Kjennerud said.
Hit by FX exposure
Issuers from both Norway and Sweden have been active in issuing FX denominated bonds, reflecting a high share of costs being in US dollars or euro. This has especially been visible in sectors such as oil services, E&P, shipping, and financials. Some Swedish real estate issuers have also printed bonds in EUR to widen the scope of their funding sources. Overall, the Nordic market, which is dominated by these four industries, thus has a high share of FX bonds, both relative to its size and relative to the proportions in comparable markets.
Investors, on the other hand, reduce FX risks through hedging. The idea is that an investor wants to reduce volatility in returns caused by currency changes, thus filtering out risks that are not related to the underlying assets. However, hedging has a liquidity risk, because changes in asset prices can lead to over- or underhedging, or because changes in currency rates increases collateral requirements. The former is (in itself) a source of FX volatility (since adjusting hedges has an impact on the currency), while the latter impacts cash balances for fund managers.
In March, both channels caused havoc on the Norwegian bond market: as asset prices fell, fund managers were overhedged, forcing them to sell kroner against euro and US dollar. As the krone fell, the value of collateral depreciated, forcing fund managers to provide more. Most often, these adjustments are done on a daily basis, and banks largely require collateral through cash only. With fund managers also facing large outflows from investors, cash balances were largely depleted. Firesales of bonds ensued, with fund managers having to accept prices much lower than underlying credit risks could explain.
Tragically, this created a negative circle, where a weaker NOK led to large asset sales, which in turn generated more margining, additional krone sales, and thus also more asset sales. Ideally, fund managers would reduce liquidity risks by selling FX denominated bonds, but in this kind of market, that was not possible, because those (few) who had cash were only willing to buy bonds deemed as 'safe'.
With basically all fund managers finding themselves in the same position, there were no buyers, only sellers. Historically, banks have been sizeable providers of liquidity in times like these, but regulatory requirements have made it increasingly costly for banks to warehouse bonds, limiting their willingness and ability to be market makers and liquidity providers.
According to Kjennerud, the market has seen a decent recovery since the summer, although much weaker than its peers. This partly reflects investors having been cautious in adding to much FX risk in their portfolios, leading to sub-par prices among large parts of the USD and EUR denominated bonds. Moreover, even though risk preferences have improved, we still see a high preference for issuers with low credit risks, such as BB's or issuers with stable cash flow but high leverage.
Kjennerud says that the market is largely back to normal, especially primary markets, which have seen high volumes in the past few months. However, he also added that "issuers that previously would have opted for issuing in dollars now go in Norwegian kroner instead."