Our investment universe consists of Danish government and Danish mortgage bonds. This also includes bonds issued by the Kingdom of Denmark, guaranteed by the Kingdom of Denmark (eg. Oeresund, Storebaelt) and bonds issued by Danish local authorities (eg. KommuneKredit, City of Copenhagen) and bonds issued by certain regulated agencies (eg. Skibskredit). Issues in Danish Kroner by Swedish Kommuninvest together with Finish MuniFin, simular to Danish KommuneKredit, can also be included in selected portfolios.
All bond issues in the investment universe must be quoted on Nasdaq OMX (The Copenhagen Stock Exchange).
In an effort to eliminate unwanted currency risk, we invest only in bonds issued in Danish Kroner.
We often invest in smaller, less liquid bond series. However, these bonds must yield a pickup compared to more liquid bonds.
The Danish bond market has throughout the last five years been affected by numerous changes, which have contributed to a reduction of the liquidity in the market. The Danish mortgage institutes have developed new instruments, particularly adjustable rate mortgages. The mortgage bond market has gone from a market consisting mostly of fixed coupon annuity loans to a market including index bonds, floating rate bonds (with or without a cap), bonds with principal repayment grace periods and 1-5 year bullet bonds (the so-called “Flex” loans).
As for the trading environment, over recent years there has been a reduction from 20-30 active brokers to no more than a handful today. This concentration has occurred at the same pace as a similar concentration on the investor side. Additionally, regulatory initiatives (eg. capital and compliance requirements) have suppressed the entry of new participants.
Less frequently traded bonds generate, over a period a higher return compared to bonds with high liquidity. Judging the value of this liquidity premium is a key factor allowing HP Fonds to achieve superior returns to our investors.
Due to the increase of diversity of bond series in Denmark, a greater number of bonds on the Nasdaq OMX can be considered less liquid. Compared to liquid bonds, illiquid bonds traditionally have a higher spread between the bid and offer price and they are traded in smaller amounts. However, on any given day, some illiquid bonds will be underpriced and some overpriced (often due to homeowner redemption demand). In practice, it is almost always possible to sell some bonds from a diversified portfolio at reasonable prices in order to meet any cash requirement of the investor.
To ensure liquidity, normally 25-35% of our portfolios are invested in liquid bonds, so that client redemptions or strategy changes can be immediately undertaken.
We have historically invested a smaller part of the portfolio in structured notes issued by KommuneKredit, Kommuninvest (Sweden) and MuniFin (Finland). These have been purchased with the option so "out of money" that it calculated as a zero cupon.
Importantly, HP Fonds has a long experience with high-coupon mortgage bonds. Historically, this segment has given very satisfying returns compared to lower coupon bonds of equivalent duration. Danish homeowners have the right to repay their mortgage at par value (i.e. they can redeem their relevant bonds at a price of 100). When yields fall, previously issued bonds rise in price and can begin to trade above par. Judging the probability and amount of redemptions for individual bonds is a key factor allowing HP Fonds to achieve superior returns to our investors.
In general, HP Fonds believes in a "buy and hold" strategy. This reduces transaction costs and again increases the possibility of better performance.
Portfolio construction is based on four factors:
- Yield spread to relevant government bond and swap yield
- Early redemption probability