Denmark's mortgage bonds have never defaulted - in 215 years. Rachel Fixsen reports on why questions are suddenly being asked

The earth beneath Denmark's pension funds has felt less than solid for some time now - in regulatory terms, at least. Waiting for Brussels to issue the latest instalment of Solvency II has created a degree of uncertainty for its largely insurance-based pension schemes.

Lower-risk investments will attract lower solvency capital requirements - that much is known. So recent jitters concerning Danish mortgage bonds - one of the country's lowest-risk investments and, along with its other covered bonds, a market four times as big as the total value of its sovereign bonds at DKK2.3trn (€309bn) - have been unwelcome for the pensions industry.

The creditworthiness of Danish mortgage bonds and covered bonds has come under the spotlight in the last few months for a range of reasons. In July, credit ratings agency Moody's downgraded the credit ratings of issuers, and demanded more collateral be put behind the bonds - despite the fact that theses bonds are used as a substitute for sovereign debt, having experienced no defaults since their creation in 1795 to finance rapid reconstruction after the Great Fire of Copenhagen.

The bonds are backed by mortgages of limited loan-to-value ratios, and crucially, they are also kept on the books of the issuing bank - unlike the mortgage-backed-securities that played such a major role in the US sub-prime crisis. So when bond issuance increases, the balance sheet of the issuer grows accordingly.

But, in the last few years, various economic shifts have been seen as threatening the bonds' solidity. Actual sale prices for Danish residential property have dropped between 11% and 16% over the last four years, according to data from the Association of Danish Mortgage Banks. Moreover, around half of all mortgages are now adjustable-rate (ARM) rather than the fixed-rate loans that used to dominate.

ARM-backed bonds are seen as riskier for two main reasons: the periodical refinancing creates a refinancing risk, and when interest rates rise, the mortgage holder may no longer be able to afford the repayments.

Of course, these risks are of limited consequence as long as the issuing bank is seen as rock-solid. But the Danish government now seems less supportive of troubled banks than before. This year it has let Amagerbanken and Fjordbank Mors fail under the Bank Package III regime (the so-called ‘bail-in' rules), which does not protect depositors or senior debt holders from losses.

For Moody's, this reinforced its assumption that the Danish government will not support any but the biggest four of the country's banks, prompting the downgrades of several mortgage bond issuers, including Nykredit, DLR Kredit and BRFkredit. In the wake of this move, it made demands that they increase the over-capitalisation on bonds from certain issuing centres, or face having the bonds downgraded.

One of the main issuers - Danske Bank subsidiary Realkredit Danmark - decided instead to drop Moody's because of the requirement, saying it disagreed with the agency's view of the Danish mortgage finance sector and its demand for extra collateral. Simultaneously it announced that it was setting up a new capital centre to issue bonds financing ARM loans; fixed-rate homeloans and ARM loans with a rate cap would still be financed through its existing capital centre.

Nykredit was able, in July, to keep its top credit ratings for most of its covered and mortgage bonds following discussions with the agency but said it was creating a new capital centre for ARMs and other types of mortgage, which of course has yet to be rated. It accepted the downgrading to AA1 from AAA for one capital centre, under which old commercial loans subject to refinancing, including ARMs, were grouped.

Moody's stricter requirements for capital would increase costs, though, it said.

The storm may have blown over for now, but uncertainty remains about the credit risks in the covered bond market in Denmark. Ratings agencies have different criteria against which they judge the overall risk of a financial instrument, and Standard & Poor's has not changed its ratings on Danish covered bonds.

Casper Andersen, S&P's covered bond analyst, says that with the focus on ARMs the agency will be taking a close look. "You can't be blind to the market. We currently have not seen market evidence of ARMs presenting a refinancing risk, but rather consider it a credit risk," he says. Waiting until the end of this year could give S&P more data on the performance of the bonds.

"Now that the issuers have split their covered bond issuance up, it will be possible to observe if there's a difference in the prices of these bonds," says Andersen. "In December you will be able to see if there is a higher cost of refinancing them; if we see there is a certain extra cost in financing ARM loans, we may again assess whether the current rating approach remains adequate."

Further downgrades to the credit ratings of Danish mortgage bonds could have an impact on pension funds under Solvency II - lower-rated bonds are likely to attract a higher solvency capital requirement. The European Commission is due to issue the Level 2 regulations of the directive in draft form this autumn, which will contain the capital requirements for Danish mortgage bonds. In the meantime, the rules used in the latest Quantitative Impact Study (QIS5) can give some guidance.

In QIS5 there was a ‘special treatment' - a lower capital requirement than for other structured products - for mortgage covered bonds and public sector covered bonds that had an AAA credit quality, and that met the requirements defined in Article 22(4) of the UCITS directive 85/611/EEC.

Danish mortgage bonds are a core holding for most Danish pension funds, including the country's giant DKK470bn ATP. "Historically we have always had a rather significant part of our investments in Danish mortgage bonds," says CIO Henrik Gade Jepsen. At the end of 2010, the holding was about DKK60bn, or 10-12% of assets.

Whether the rating downgrades by Moody's in the summer were justified is an open question, he says, but points out: "If you look at the issue more broadly, there's a clear trend globally for ratings agencies to evaluate their ratings, and there's a trend towards lowering them."

Gade Jepsen says the bonds do have a small additional risk charge compared to government bonds, and that this charge will increase if they are not AAA-rated. "But I wouldn't expect it to have significant implications for our own portfolio, at least," he notes.

Pension funds are unlikely to reduce their overall holdings of the bonds significantly, he believes, although he thinks there could perhaps be some switching within the mortgage bond universe. "Danish investors are very familiar with Danish mortgage bonds," he explains.

There are worries that the increased use by covered bond issuers of different issuing centres - which are used to group bonds of a similar risk profile, thereby allowing some of the issuing centres unequivocally to maintain their top ratings - could ultimately damage liquidity in the market, according to Heiko Langer, senior covered bond analyst at BNP Paribas. But this depends very much on the size of the split. If issuing were divided between, for instance, a DKK9bn pool and a DKK1bn pool, then this would make little difference to the demand for the larger pool, he says.

Steffen Mielke, head of fixed income at PensionDanmark (which is not affected to any great extent by Solvency II because its pension product is unit-linked rather than guaranteed) says the high level of liquidity is a major strength of the Danish mortgage bond market.

"If in the long run the market gets less liquid, then that would be a problem," he says. "But there is no doubt that the mortgage institutions are very aware of that."

Gade Jepsen sees the reduced-liquidity scenario as a possibility: "I do think it could happen, but it's important to say that Danish mortgage bonds are very liquid compared to other markets."

On the one hand, it is good for the market that the bond issuers are addressing the downgrade problem, he says. But the fact that they are doing this in different ways could make it difficult for investors to find their way within the market. After all, nobody wants to have to read pages of conditions before buying a simple mortgage bond.