Since summer 2007, the financial markets have been in turmoil and prices of many assets have been tumbling. Mainly leveraged investors started to head for the exit and this put more pressure on – even high quality – securities. A scramble for liquidity seems to be the norm nowadays, exacerbating the problems in the financial system. Yet investors can benefit from the dislocation if they have enough risk budget at hand to pick high quality investments at attractive prices.

Many Nordic investors, in particular, have generally kept their powder dry and are now in an excellent position to take their pick of the best assets when adding risk.

Many institutional investors in the Nordic market have a high quality bias to their fixed income portfolios, with the majority of the assets invested in government bonds and swaps. Allocations to the riskier sectors of the fixed income world are typically a lot smaller. Nordic institutional investors are therefore, in many cases, in a fortunate position – being able to avoid a lot of the direct fallout from owning US subprime mortgages in their fixed income portfolios. In addition, many pension funds in the region were relatively well positioned heading into the crisis with an underweight position in riskier fixed income securities relative to their strategic asset allocation targets.

Within fixed income, a substantial number of large Nordic pension funds are either increasing the amount of riskier fixed income assets held or are looking to increase their position over the coming year, for good reason: they are trying to capitalise on the attractive levels that exist in the marketplace at the moment, with a view that holding these securities over a two to three-year period promises attractive total returns relative to the risk in these positions.

This trend is likely to continue and could even increase in pace over the coming year as investors gain more and more confidence.

Many investors are focusing their increased allocation on riskier fixed income assets: emerging markets, high yield or corporate securities. Of particular interest for Nordic investors could be higher quality asset-backed securities (ABS), which includes European mortgage securitisations.

The European mortgage market is fundamentally in a better state than the US one. The European real estate market has been less overheated as a whole, and a pronounced subprime segment like that in the US did not exist to the same extent. In addition, a European uniform real estate market does not exist. Lending practices, loan terms, fixed interest arrangements and developments in house prices can vary widely across the individual countries. For Nordic pension funds with a traditional exposure to real estate, investing in European mortgage-backed securities (MBS) can be an interesting way of gaining exposure to other European real estate markets and to diversify a regionally concentrated exposure.

The re-pricing of risk with reference to the ABS market has come in an undifferentiated way. The main trigger has been the news of downgrades of some US subprime MBS by rating agencies due to the expected higher losses in the underlying portfolios. The high level of analysis required when investing in ABS led to a very cautious attitude towards all types of securitised products and a sharp drop in demand.

A factor that magnified the effect is that the European ABS market is relatively young compared to its US peer. Many investors are still not well equipped to analyse and assess the embedded risks of ABS securities. As a result, many investors relied mainly on the rating agencies, whose sudden downgrades of the

US subprime accelerated the spiral in the reassessment of risk.

Consequently, many ABS are currently trading at a level that could be described as distressed. This means that many can be purchased at prices that are lower than their implied values and quality. In many cases, the discount value is due to the poor liquidity conditions and not to the deterioration of the underlying assets (an example could be the seasoned residential MBS backed by Italian or Dutch real estate, which have not suffered from housing bubbles). The indiscriminate markdowns in the European ABS market have created attractive opportunities especially for those investors and active asset managers who have the appropriate know-how to assess the fundamental value of the underlying assets.

When confidence returns to the markets and liquidity conditions improve, asset prices should return to more normal or more fundamentally justified levels. This normalisation should eventually favour high quality ABS – however, a precise timeline for the normalisation process is difficult, if not impossible, to map out. There is some consolation, though. Taking your pick now of ABS that meet their regular payments offers attractive value on a risk-adjusted basis while waiting for the reduction in risk premia, especially when bought in the primary market. Investors, who are less sensitive to short-term price volatility, could also look at the secondary market for attractive entry opportunities.

Investors should keep in mind that markets could remain volatile with further price markdowns and liquidity contraction going forward. Therefore, a longer-term view and the ability to hold positions through the current financial market volatility are essential. It is precisely this that makes Nordic institutional investors excellent candidates to take advantage of the situation and take their best pick of high quality bonds at a time when other investors lack the will or the ability to do so.

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