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Sovereign Bonds: Denmark: an unlikely haven?

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Denmark's bonds, perceived as a safe haven from volatility in the euro-zone, have the lowest yields on the market. But Pavle Sabic argues that its fundamentals versus its Nordic neighbours suggest this is not simply about credit risk

At first glance, Scandinavia's reputation as a safe haven is well deserved. Total debt
 as a proportion of GDP is, on average, less than half that of the European Union. Perhaps this is why sovereign debt yields are low across the board.

Indeed, as of September 2012, the Swedish government two-year note yields just 0.793%, while the Norwegian equivalent yields 1.433%. Below these come the German two-year bond at 0.005%, and Danish government debt, the lowest of all, which yields -0.113%.

These low yields can be taken as a sign of market confidence in these countries: the lower the yield, the lower the perceived risk of default. But while the economies of Sweden and Norway are forecast to do well in the future, some think question marks remain over Denmark's future economic performance.

A fragmented picture

Certainly, exploring the state of Scandinavian economies in further detail it seems that, despite benefitting from the lowest government bond yields, Denmark is performing the worst. Total state debt reached DKK758bn (€102bn) - or 43.5% of GDP - at the end of 2011, according to the Danish National Bank. While this is still less than half the EU average, it compares poorly with Sweden, where public debt as a proportion of GDP is healthier at 38.4%.

Indeed, the Swedish current-account surplus continues to grow - reaching SEK242.8bn (€29bn) in 2011 from SEK229bn a year ago, according to data from the Danske Research Nordic Outlook report of July 2012. And in Norway, GDP growth continues above the long-term trend.

 Observers are nervous about Denmark - certainly regarding the risk of government intervention in its banking sector. Since 2007, the country has experienced 12 bank failures. Although these banks were small by international standards, the failure rate is unusually high for a developed market. Added to this, a significant piece of Danish legislation written in 2008 to ensure financial stability - commonly referred to as Bankpakke I - contains the option for a government guarantee on privately issued banking debt.

By the end of 2010, 50 banks had issued DKK193bn of government guaranteed debt, constituting around 30% of all outstanding senior bank debt issued by Danish banks. If the situation deteriorates, the potential for government intervention to save the banking sector will increase.

Indeed, according to S&P Ratings, up to 15 more Danish banks could be at risk of becoming insolvent, causing an estimated sector loss of between DKK6bn and DKK12bn over a three-year period. (‘Banking Industry Country Risk Assessment: Denmark', 17 July 2012.)

Furthermore, Denmark is also struggling with a housing crisis - house prices have dropped 25% since their peak in 2007. Although the prices for single-family homes have fallen back to affordable levels and  this could be interpreted as a positive market correction, S&P Ratings expects real estate prices to fall further in 2012 and 2013. (‘Deleveraging Denmark - How Much Further Is There To Go?' 7 May 2012.)

Asset-class discrepancies
With these concerns about the state of the Danish economy, it is not a surprise to see that the cost of ‘insurance' against its default - as demonstrated by credit default swaps (CDS) on its national debt - has increased significantly since the third quarter of 2011.

The high CDS spreads are no doubt a symptom of its uncertain banking sector and falling house prices, among other factors.

According to another measure of credit risk - S&P's Market Derived Signal (MDS), which applies a relative ranking based on CDS prices - Denmark has the worst rating among all ‘AAA'-rated countries in the EU as of 6 July 2012. Indeed MDS has diverged from the equivalent of ‘AAA' since late 2011
.
But with the risks outlined above - clearly priced into CDS instruments linked to sovereign debt - the country is still able to borrow at rates well below its neighbours. It is here that its commonalities with Norway and Sweden are helping, such as its record of fiscal discipline and a below average debt-to-GDP ratio.

Yet Denmark distinguishes itself from Sweden and Norway as its currency is pegged to the euro through the Exchange Rate Mechanism.

 This means that if the economic picture shifts suddenly, the risk of the Danish krone weakening is less than that of its neighbours - the Swedish and Norwegian currencies float, but the krone could be pegged against a new German currency in a disaster. While benefitting from this perceived German stability, assets in Danish currency would also avoid the disruption and bureaucracy involved in the creation of a new deutschmark.

Re-denomination risk
As such, the complex interactions between
the euro-zone crisis, positive and negative signs from the Danish economy and asset classes related to Danish government securities seem to bear out European Central Bank president Mario Draghi's comments on 2 August 2012 that re-denomination risk is a key driver of yields in the euro-zone.

While there are considerable concerns about Danish banks and the ongoing housing crisis, the Danish bond market appears very healthy and demand for its bonds is increasing. And a key factor here is the perceived stability of its currency.

Pavle Sabic is a solutions architect at S&P Capital IQ

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