International investors are overtaking Danish pension funds and insurers as the biggest buyers of the Nordic country’s covered mortgage bonds, creating new risks for the $500 billion market.
The institutional investors have been trimming their holdings as the surge in foreign buyers pushed yields to record lows on the world’s biggest covered bond exchange. International investors held more of the bonds than domestic pension funds and insurers in seven of the past 12 months, according to Danish central bank data.
Global buyers have lowered mortgage rates to less than what the U.S. government pays to borrow, easing pressure on Danish households, the world’s most indebted. These investors have also introduced a peril into the two-centuries old system: demand evaporating as quickly as it has appeared.
“There is much less loyalty among foreign investors to the Danish bond system,” said Jens Hallen, a London-based senior director for financial institutions at Fitch Ratings Ltd. Institutional buying “has been a key mitigating factor for us when assessing re-financing risk for Danish mortgage bonds.”
Denmark’s mortgage market, which was created after a fire in 1795 burnt down large swaths of Copenhagen, is a cornerstone of the country’s economy and relies on dependable buyers. Lenders sell covered bonds backed by mortgages to finance almost 100 percent of home purchases and equity loans, stimulating consumption that makes up about half of the country’s gross national product.
Household Debt
Roughly one in three loans has to be refinanced each year, after lenders began offering mortgages with rates that adjust annually. At $151 billion, bonds with maturities of one year or less represent more than 40 percent of Denmark’s economy. Households would be hurt if demand for the bonds dried up in a crisis. Household debt, comprised mostly of mortgages, is three times the size of disposable income in Denmark.
Pension funds say they’re not abandoning the market. Low yields are forcing them to reduce holdings and look elsewhere for higher returns to meet obligations to pensioners.
“We don’t get enough of a return on the bonds,” said Hasse Joergensen, chief executive officer of Sampension, a union-based fund that manages retirement programs for municipal and central government employees.
Fitch’s Hallen is warning that the rating company may downgrade Denmark’s two biggest issuers, Danske Bank A/S and Nykredit Realkredit A/S, if foreign ownership of the covered bonds continues to climb. International investors now own about one in five of the bonds, central bank data show.
Global Demand
“If the trend continues and we see it go from 20 to 25 percent, then we might have to reassess the stability of the ownership,” Hallen said.
Global demand for covered bonds soared in the aftermath of the 2008 collapse of Lehman Brothers Holdings Inc. as investors dumped unsecured bank lending for the safety offered by securities backed by collateral. The amount outstanding doubled in five years to peak at 2.25 trillion euros ($2.81 trillion) in 2012, according to the European Covered Bond Council, as countries including Canada, New Zealand, India and Mexico began adopting the approach to finance home lending.
Foreign investors fleeing Europe’s sovereign debt crisis began pouring into the Danish market in 2010. They have been attracted by Denmark’s long track record with the securities, AAA credit ratings and a legal structure that protects bond holders. In the pre-crisis years, foreign holdings hovered around 13 percent while pension funds and insurers held about twice that, according to central bank data.
Mortgage Rates
Foreign investors surpassed Danish institutional buyers in the size of their holdings for the first time in July 2013 and again in eight of the last 13 months through September, the data show. Danish insurers and funds held 519 billion kroner ($87 billion) in covered bonds, or 17 percent of the market, at the end of September. That compares with 566 billion kroner, or 19 percent, held by foreign investors.
“It’s not that we want to reduce,” Joergensen of Sampension said. “But we want to have a total portfolio that gets a sensible return and the more that we can find alternatives to bonds, the better.”
High levels of foreign investment don’t necessarily lead to instability. International investors hold a record $6.07 trillion of Treasuries, about 49 percent of the $12.294 trillion U.S. government debt market, according to Treasury Department data. In the Dutch covered bond market, German and Austrian investors account for 45 percent of transactions, according to an August report by ING.
Housing Bubble
Foreign buying in Denmark has pushed rates on adjustable-rate mortgages below 0.5 percent and enabled banks in August to offer 30-year home loans at 2.5 percent. U.S. 30-year Treasuries yield around 3 percent.
The low rates have helped contain foreclosures after the housing bubble burst in 2008 and enabled borrowers to shrink their debt. Households now repay about 31 billion kroner annually, about 40 percent more than they paid in 2009, the central bank said last month.
During the peak of the financial crisis six years ago, foreign investors initially dropped Danish assets amid the panic that followed Lehman’s collapse. Denmark’s central bank raised its benchmark rate to an eight-year high to counter the sell- off.
“The foreign investors are the most likely to take money from Denmark if something happens,” Hallen said. “We’ve seen it in a few cases already, foreigners pulling out in times of stress.”
Averting Crisis
Denmark has since taken several steps to avert a mortgage bond crisis. Its Folketing, or parliament, earlier this year passed a bill to extend maturities on short-term bonds if investors flee and an auction fails or rates rise more than 5 percent. And the nation’s bank supervisor is imposing new caps on loan products that need frequent refinancing.
“The Danish pension funds and insurers hold both long and short-term bonds, so it’s in their interest to support the system and reduce the risk of auctions failing,” Hallen said.
Nykredit, Europe’s biggest issuer of covered bonds, says it’s monitoring holdings.
The Copenhagen bank estimates 22 percent of its bonds are held by financial institutions outside Denmark. That includes Danish investment funds based in Luxembourg and Danish banks offering asset management in other European countries, Soeren Holm, Nykredit’s chief financial officer, said.
New Rules
“We believe our foreign holdings are at a very good level,” Holm said. “It is good to have diversity on the one hand, and on the other, as Fitch is saying, foreign holdings shouldn’t be too high.”
Holm said that even in a crisis, new European-wide rules that require banks to hold liquid assets will support continued demand for Denmark’s bonds.
The refinancing by mortgage lenders each year makes Denmark the country with the highest issuance rate, according to the ECBC. In September, 901 billion kroner worth of securities, out of 3 trillion kroner, had maturities of one year or less, according to central bank data.
The bid yield to maturity on Nykredit’s 3 percent bond maturing 2044 was around 2.8 percent in Copenhagen trading yesterday. Danske subsidiary Realkredit Danmark’s 2 percent bond maturing 2016 yielded 0.137 percent.
Declining market share “is in no way a signal that we have less confidence in the system,” said Christian Sagild, chief executive officer of Topdanmark A/S, an insurance company. “I imagine it will shift back if the spreads widen again and mortgage bonds get cheaper.”
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