Danish mortgage bonds, UBP

DANISH MORTGAGE BONDS

By Michael Denbaek and Peter Thiberg in cooperation with Astrid Gehoel-Ceelen

In the current low yield environment, Danish mortgage bonds are a very attractive alternative for EUR, USD and JPY fixed income investors, given that Danish mortgage bonds offer a relatively high expected return and a very low credit risk.

DENMARK

Denmark is a AAA-rated small open economy. Since 1982 the currency has been pegged to first the Deutsche Mark and since 1999 the Euro. The Danish central bank has a substantial currency reserve in order to support the DKK if ever needed. (The current size of the reserve is approximately 60.6 bn. Euros.) This ensures that the currency rate between Danish kroner and Euro is kept in a narrow range. Furthermore, the official Danish deposit rate is lower than the ECB’s, which provide a gain for those wishing to hedge the DKK into EUR. In addition, the Danish economy is faring better than many eurozone countries. The fiscal balance is sound and Denmark has a high trade balance surplus.

BORROWERS

The Danish mortgage bond market has existed since 1797 and is the largest covered bond market in Europe (393 bn. Euro). Almost all real estate is financed through issuance of mortgage bonds rather than bank loans. Most Danes own their own houses and apartments and consequently have high levels of gross debt. However, looking at net debt (including pension savings), Danish households are among the wealthiest in Europe.

INVESTORS

The primary investor base are the Danish pension and financial sectors. They allocate large amounts to Danish mortgage bonds as the base part of their portfolios. The share of foreign investors has been rising for the past years and is currently 21.3% and in the segment of callable bonds it’s as high as 34.1%. The explanation for the recent rise is the attractiveness of the expected return as well as the extremely low yield on

Figure 1: Volume in European covered bond markets by country (EUR bn.)

alternative AAA-rated fixed income investments.

CALLABLE MORTGAGE BONDS

The Danish mortgage bond market consists of non-callable bonds, floating rate notes, and callable bonds. All are issued under the Covered Bond label, ensuring enhanced credit quality compared to ‘standard’ mortgage credit bonds. They are AAA-rated and highly liquid, with daily issuance and a very active secondary market. Callable mortgage bonds are the most interesting part of the market (and form approximately 33% of the outstanding bonds) since they offer a substantially higher expected return than comparable AAA-rated fixed income investments worldwide (hedged to the same currency).

The callable bonds are callable by individual borrowers at par effectively 4 times per year. Every mortgage loan is financed by issuance in a particular bond. If a borrower has a loan and he wants to refinance into a different loan with more favorable terms, he can chose to call/ redeem his current loan and take a new loan. If the price of the bond of his current loan is above par, the borrower will exercise his option to prepay and he will inform his mortgage bank. The mortgage bank publishes prepayment information every week and each quarter the collected prepayment amount is paid out pro rata to each bond holder. The investor will experience a cash inflow and a reduction in nominal for each callable bond, depending on the specific prepayment ratio. Since bonds only prepay when market prices are above par,

the investor will incur a ‘loss’ as parts of his holdings are converted to cash at par. This is the risk of early prepayment and this is what the investor demands a premium for.

Additionally, if the price of the bond falls substantially below par, the borrower can ask the mortgage bank to buy back their exact bond and issue in another bond priced close to par. Borrowers have a significant financial incentive to buy back their bond when yields are rising significantly. Firstly, a buy back below par will reduce the remaining debt. Secondly, interest payments are tax deductible, so a higher interest rate allows for a larger tax deduction. All in all, this feature means that when interest rates are rising, borrowers’ behaviour increases demand for Danish mortgage bonds. This is why Danish mortgage bonds tend to outperform equivalent bonds when interest rates are rising.

VALUATION AND RISKS

So how do we as investors evaluate this prepayment risk? In order to calculate risk numbers, a statistical mortgage bond model is needed. The model can be divided into a prepayment model and a valuation model. The prepayment model estimates prepayment behaviour of borrowers in every possible future interest rate-scenario. This is done using a large data set of historical prepayments as well as other factors such as borrower composition and the distribution of the

Figure 2: 12M Horizon Return (RoR) Hedge to EUR Figure 3: Illustration of Negative Convexity

Source: SEB

sizes of the underlying loans. Future cash flows are then adjusted to expected prepayments and a more traditional valuation model is applied to the adjusted cash flows. This model is then utilized to calculate option-adjusted risk measures such as duration, convexity and spread (OAS). The ‘option’ refers to the fact that the borrower has the option to prepay. In practice a typical 30-year callable mortgage bond will have an option-adjusted duration (OAD) of 7-8 years at time of issuance. If interest rates subsequently fall significantly, the OAD will fall (since prepayments become more likely) and if interest rates rise, the option-adjusted duration will rise (since prepayments become less likely). This estimation is done for every single callable bond every single day and each bond will have its own specific characteristics. Figure 3 shows an illustration of this relationship. The green line represents a callable Danish mortgage bond, while the blue line is a non-callable bond.

CONCLUSION

The purpose of this article is to highlight the existence of a very large and for many investors alternative fixed income market, which offers the potential for very attractive returns and diversification whilst maintaining the highest credit quality. During the most recent years, more and more international investors have recognized the attractiveness of Danish covered bonds, especially the callable bonds. We can only encourage you to get involved as well. «

This article was written by Michael Denbaek, Team leader & Portfolio Manager fixed income, SEB and Peter Thiberg, Client Executive, International Asset Management Sales, SEB in cooperation with Astrid Gehoel-Ceelen, Managing Director, Head of Institutional & Wholesale The Netherlands, UBP.