Corporate bond diversification: the case for Nordic unrated bonds 

Corporate bond diversification is typically built across issuers, sectors, geographic regions and credit ratings, so that a portfolio does not depend on any single source of risk. Judged by these measures, many portfolios look well diversified.

Why diversified credit portfolios may not be

In practice, however, many portfolios still rely on a relatively small number of underlying return drivers. This is because large segments of the credit market are connected through common benchmarks, investor bases and investment constraints.

A portfolio can hold a large number of bonds while remaining concentrated in the same underlying risks and return drivers. Structurally different markets can broaden the sources of return and diversification beyond what additional bonds from the same markets can offer. 

How market structure affects corporate bond diversification

Our latest white paper examines how market structure can influence portfolio diversification. Does it matter how bonds are issued, who can own them, how liquid they are or whether they are included in benchmark indices?

We address this through the Nordic corporate bond market, with a particular focus on its unrated segment. While Nordic corporate bonds are already part of broad European credit portfolios, exposure to the parts of the market that differ most is often missing. Unlike in the European and US credit markets, the Nordic market's key characteristics are not as tightly linked. Credit ratings, currencies, fixed- or floating-rate structures, investor bases and benchmark eligibility do not necessarily go hand in hand. This makes it possible to analyse the effects of market structure separately from conventional credit and interest-rate risk.

Market structure is clearly reflected in the pricing of Nordic corporate bonds. Even after accounting for traditional factors such as credit risk and duration, investors demanded different yield spreads depending on how easily a bond could be traded and whether it paid a fixed or floating rate.

Nordic unrated bonds under stress: 2020 vs 2022

Market structure also shapes how corporate bonds behave during periods of market stress. During the 2022 interest-rate shock, Nordic unrated bonds lost considerably less value than Nordic investment-grade bonds, which carry high credit ratings. Unrated bonds lost 2.7 percent, while Nordic investment grade lost 14.0 percent. During the 2020 credit shock, however, unrated bonds suffered greater losses than investment grade but held up better than both Nordic and European high yield.

This suggests that market structure does not eliminate risk. Rather, it changes which risks matter most in different market environments.

Diversification rather than excess returns

One of the key findings of our analysis is that the portfolio benefit from Nordic corporate bonds came from diversification, not from statistically significant excess returns. Nordic high-yield and unrated bonds offered combinations of risk and return that conventional benchmark markets could not fully replicate. As a result, exposure to Nordic corporate bonds improved portfolio risk-return trade-offs and expanded the historical efficient frontier – making it possible to achieve either higher returns for the same level of risk, or the same return with less risk.

This benefit may persist because rating requirements, benchmark eligibility, small issue sizes and liquidity constraints prevent all investors from accessing the market on equal terms. 

Implementation considerations for investors

Capturing the benefit means managing the same constraints that keep it from being competed away. Smaller issue sizes and thinner secondary-market trading mean that position sizing, holding periods and the ability to hold bonds to maturity deserve particular attention.

Exposure to Nordic currencies such as the Norwegian krone and the Swedish krona adds a further decision: whether, and at what cost, to hedge currency risk back to the portfolio's base currency. And because many issuers are unrated, credit assessment rests on the manager's own fundamental analysis rather than on agency ratings – making the depth of that research process a central point of due diligence.

Look beyond traditional measures of diversification

The number of bonds in a corporate bond portfolio says little about how many independent risks it contains.

Issuers, credit ratings, sectors and geographic regions describe how capital is allocated across securities, but they do not necessarily reveal whether a portfolio is exposed to different underlying return drivers. Diversification should therefore be assessed not only by the number of securities or other traditional measures, but also by the variety of risks that drive portfolio returns.

Although our white paper focuses on the Nordic market, the diversification benefits created by market structure are relevant beyond the region. At the same time, the results highlight Nordic corporate bonds as an effective source of additional diversification.

Accessing the full Nordic opportunity set

Many institutional investors already have exposure to Nordic corporate bonds. However, this exposure is concentrated mainly in rated, euro-denominated and benchmark-eligible bonds – the segment that most closely resembles the broader European credit market.

The question is therefore not whether to enter an unfamiliar market, but whether the Nordic exposure already held brings anything the rest of the portfolio does not. Capturing the structurally different part of the market requires exposure to unrated and non-euro-denominated bonds, either through a dedicated allocation or by replacing part of the existing Nordic exposure. The number of Nordic bonds in a portfolio says as little about its diversification as the number of bonds overall.