X marks the treasure spot
Danish mortgage bonds have long been an attractive fixed income investment for Danish investors. Now foreign investors have also discovered the advantages of Danish mortgage bonds which offer a considerably yield pick-up and strong diversification effects.
“There is no such thing as a free lunch”. A classical economic dogma and every rational economist knows it. But economic and financial doctrines do not include the rejection of hidden treasures. Normally an “X” marks the spot of a hidden treasure packed with gold. In this case, the “X” is Denmark and the gold is Danish mortgage bonds. Danish mortgage bonds are characterised by high absolute and relative returns, a strong diversification to other asset classes, high liquidity and high credit ratings.
As with every treasure hunt one has to be well prepared. Danish mortgage bonds are quite complex and hard to handle. Specialised models, a high level of specialised knowledge about the mortgage market as well as knowledge about derivatives are needed to deal with prepayment estimation, market behaviour, interest rate modelling, derivative pricing and more. If one is equipped with these competencies the gold is right there in the Danish mortgage market, ready to be extracted in the form of strong diversification, low credit risk, high liquidity and a significant return. Our company has specialised in this market and has DKK 200bn (e27bn) Danish mortgage bonds under management.
Danish mortgage bonds are a part of the covered bond market and have been an attractive fixed income investment for Danish investors for a generation. Issuing mortgage bonds in Denmark is restricted by a comprehensive legislation which considers both debtor and investor interests and provides a high security. One important thing is that the bonds have a preferential claim if the mortgage credit institute enters into bankruptcy. Even more important, the issuance of mortgage bonds must obey a principle of balance which requires that payments from debtors and payments to creditors must balance within very strict limits. This rule is met by the issuance of bonds with the same maturity, currency and payment schedule as loans granted – an almost complete balance between the bonds issued and the loans. This de facto means that the mortgage issuers have no FX and interest rate risks. The balance principle is a part of the Mortgage Credit Act’s investor protection. In a report from 2002, Moody’s regulators said this about the balance principle: “These regulations are the most detailed and restrictive, which we have seen so far, providing significant support for the Danish mortgage system.”
The Danish mortgage market is very comprehensive with a wide range of mortgage-based loan types and thus a broad variety of mortgage bonds. At present, there are seven limited liability companies issuing mortgage credit institutes in Denmark. The mortgage bond market mainly consists of three types of bonds all with different maturities and different types of amortisation. The three main types are non-callable bullet bonds, of which the majority is used to back Adjustable Rate Mortgage Loans, also known as ARMs, fixed coupon amortising callable bonds with maturities of between 10-30 years, and recently a new type of capped floating rate bond has been introduced also with a maturity of 10-30 years. From an investor’s point of view, the capped floating rate bonds and especially the callable bonds are the most interesting ones due to the built-in derivative elements which respectively are a sold interest rate cap and a sold call option.
Fixed coupon callable mortgage bonds constitute the main part of the Danish mortgage market. The mortgage loans are granted as annuity loans. The interest payments and instalments made on the payment dates are distributed to investors, corresponding to the percentage of bonds drawn, so that any investor’s holding in a given bond series will correspond to the overall percentage of bonds drawn in that series.
If a borrower has obtained a callable mortgage loan, he can redeem the mortgage loan at par at each term in the duration of the loan. In fact the borrower is buying a call option with the right to exercise it should the mortgage bond trade above par. On the opposite, the investor is selling an equivalent call option. As a result of the prepayment option, investors have uncertainty about the future cash flow of the bonds. The fact that the built-in option is debtor exercised gives irrational prepayment. This irrationality and thereby uncertainty about future cash flow and valuation adds to a higher yield spread to duration equivalent non-callable bonds.
The transparency and substantial legislation of the Danish mortgage market combined with the solidity of the Danish mortgage issuers is directly readable in the credit ratings of the issuers. As seen in table 1, the six Danish mortgage credit institutes that have had their bonds rated by Moody’s have all obtained a highly satisfactory rating at the levels Aaa or Aa1.
In the report from 2002, Moody’s points out that the Danish mortgage system is characterised by cost-efficiency, a very solid asset portfolio, is well capitalised, has a just legislation and is competitive. As a curiosity it is appropriate to mention that in the more than 200 years of existence of Danish mortgage bonds there has not yet been a default of a Danish mortgage issuer.
The Danish mortgage bond market is the second largest in Europe, exceeded only by the German market. The nominal value of outstanding mortgage debt in the Danish mortgage bond market currently exceeds DKK 2,000bn (e269bn). The Danish mortgage market comprises 75% of the total Danish bond market inclusive of government debt. The mortgage market is experiencing continuous growth primarily as a result of the stable growth in the Danish economy followed by rising property prices. The big market size is directly transmitted to a significant liquidity and a very high turnover. The largest mortgage issues have an average daily turnover which exceeds twice the average turnover in Danish government bonds and treasury bills. The high daily turnover is supported by an effective interbank market-maker agreement.
Danish mortgage bonds have historically yielded good returns compared with Danish and European government bonds, as well as the German Pfandbriefe. Table 2 illustrates the relationship between risk and return for the different fixed income asset classes since 1994.
In addition to the high absolute return and relative performance, Danish mortgage bonds also have a unique and strong diversification to other asset classes. The low correlations give Danish mortgage bonds a unique advantage in fixed income portfolios and mixed asset portfolios. In the table, the correlations between Danish mortgage bonds and Danish and German government bonds indices are shown. Correlations can be as low as 0.19, which is a better diversification effect than BBB-rated corporate bonds would bring to a fixed income portfolio.
Foreign investors are showing an increasing interest in the Danish bond market. Although Danish government bonds have long been in demand by foreign investors due to their yield spreads to German and other European government bonds this demand has declined. The yield pick-up has narrowed. Hence, investors are looking for attractive and fair yield pick-up elsewhere. Some foreign investors have turned their focus to Danish mortgage bonds which offer a considerably yield pick-up and strong diversification effects. Today foreign investors own approximately 32% of the Danish government bonds but only 13% approximately of the Danish mortgage bonds. We expect this number to increase considerably as more foreign investors discover the gold.
Tom Rosenkrans is a portfolio manager, Kåre Michelsen is chief portfolio manager and Lars Dam is chief analyst at Danske Capital in Copenhagen