With outstandings of some Dkr1.4tr (about Eu200bn) at the end of last year, the Danish mortgage bond market is the sleeping giant of Europe. Second in size only to the German Pfandbrief market of all the non-government bond sectors in Europe, the products also dominates the Danish bond market, representing 66% of its nominal value. Neil Day reports.
Historically, international participation in the Danish mortgage market has been low, but Denmark's institutions are pushing their product outside their home market. One of the key drivers of this effort is the belief that Denmark will join the euro - whether that be sooner or later - and the challenges and opportunities that this will present.
"Joining the euro would offer the market the ultimate opportunity for us to increase our investor base," says Martin Gregersen, an analyst at Realkredit Danmark. "We have the second largest outstanding amount of non-government bonds in Europe, but because almost all our bonds are denominated in Danish kroner, we cannot sell internationally as well as the German, French and Spanish mortgage banks, for example.
"While there is definitely a fear that some of our traditional domestic investors would move out of our bonds and into foreign paper, all our bonds would be denominated in euros and that would allow us to attract far more investors. The bottom line is that we would benefit and I believe that we would get better prices than we do today."
In terms of credit quality, there is no question that Danish mortgage bonds would attract interest. The key determinants of the safety of the product - alongside the credit quality of the underlying mortgage portfolios - are the "balance principle" and bankruptcy-remoteness enshrined in Danish law.
"The Danish legal system contains very detailed and restrictive regulation in support of the mortgage bonds issued by the country's mortgage credit institutions," said Moody's (which rates all Danish mortgage bonds Aa2 or higher) in May 2002. "The global balance principle ensures the closest possible match between mortgage loan payments and the bonds issued, thus keeping risks down. Moreover, the mortgage bonds are legally ring-fenced from the mortgage credit institutions' creditors and therefore bankruptcy-remote."
The rigidity of the balance principle means that Danish mortgage bonds must match almost identically the terms of mortgages taken out in Denmark. And since a typical Danish mortgage is a 30 year fixed rate annuity that can be repaid at any time, the majority of Danish mortgage bonds pay back both interest and principal over the life of the bond and can be called at any time.
The result is that some Dkr1tr of callable bonds are outstanding in the Danish mortgage market.
An international future?
The pricing of callable issues is, in the words of one Danish observer, "pretty intriguing". So given that the experiments in more simple once-only callable issuance in euros this year from the likes of the European Investment Bank, Freddie Mac and KfW have shown that interest in the product is limited, will the more complex callable Danish mortgage bonds really succeed in attracting pan-European demand?
The introduction of adjustable rate mortgage (ARM) loans in recent years, on which the interest can be reset every one to 10 years, has, however, resulted in an increase in bullet issuance. With interest rates having been on a downward trend and lots of publicity about the product in Denmark, borrowers have been keen to take out ARMs and bullet issuance's share of outstandings had risen to 31% of the mortgage bond market by July 2003.
Given the much simpler pricing of bullet debt and the fact that it is the bread and butter investment of the vast majority of European fixed income investors, one might expect the percentage of foreign ownership of Danish mortgage bonds - currently in the low teens - to be biased towards these and away from the more complex callable annuities. But according to market participants, this is not the case.
"The distribution of foreign ownership among our bonds points to the fact that the level of liquidity in a particular bond series is the most important factor," says Michael Carlsen, vice president of investor relations at Nykredit, the second biggest player after Realkredit.
Data from Statistics Denmark for the first quarter of 2003 appear to back this up. Of Nykredit's outstanding Danish krone bonds, the six with the highest proportion of foreign ownership are callables. The bond with the highest share is Nykredit's 6% 2032 issue, totalling Eu911m equivalent, of which around a quarter is held by foreign accounts.
The three Nykredit bonds with the highest proportion of foreign ownership are euro denominated issues. Danish mortgage banks use these to match euro mortgages. However, interest in the product has fallen as Danish interest rates have converged with euro rates. The result is that the percentage of new lending by Nykredit in euros is less than 10%.
One factor helping attract international investors to the market has been the creation of a Lehman Brothers index for the market. Indices created by domestic institutions were already available, but the entry of a large international player into the market boosted non-domestic interest in the product.
International participation should increase still further should Lehman include Danish mortgage bonds in its Pan-European and Global Aggregate Indices in July next year, as it has announced it might. "Since Lehman said that Danish mortgage bonds could feature in their international indices, we have seen a lot more foreign accounts going into the liquid callables," says Jesper N?rgaard, first vice president responsible for mortgage trading at Danske Bank.
Not with a bang...
The balance principle on which the Danish mortgage bond market is based means that every time a borrower takes out a mortgage to buy a property, the respective mortgage credit institution must increase the outstanding amount of the matching bond series. This means that mortgage bond issuance takes place every day, through taps.
Refinancings of ARM loans takes place in December, resulting in a surge in issuance, but apart from this, there is no focal point for investors as there is through the launch of, for example, a jumbo Pfandbrief, with all the marketing that goes on from the issuer and its syndicate of banks. So in an increasingly competitive international market where even some euro zone sovereigns are moving from auctions to syndication to launch new issues, will Danish mortgage credit institutions be able to capture international investors' attention?
An official at one issuer acknowledges that the tap method could be a drawback on the international stage. "Danish investors are used to it, but it might be a problem for international investors," he says. "However, the reason that we can't change the issuance technique is the balance principle.
"We cannot simply estimate what the funding needs are going to be over, say, the next couple of months, as the US agencies and European mortgage banks do. We have to match our funding much more strictly."