Artikel i Hedgenordic september 2016

22.09.2016

Denmark’s 200 year old mortgage bond market,
valued at around 2.75 trillion Danish Krone (DKK),
is larger than the country’s GDP of around 2 trillion
DKK. The asset class has distinctive features. “It is very
easy to repossess, and sell, property if borrowers default”
according to HP Hedge co-portfolio manager, Michael
Nielsen. Unlike in the US, lenders in Denmark have full
recourse to other assets and income of the borrower, in
addition to the property on which the mortgage is secured.
The frequent claim that Danish (and indeed Dutch)
mortgage bonds have never defaulted needs some
clarification. “Though some individual borrowers have
defaulted, mortgage bondholders have never lost money
nor seen a cut in payments” Nielsen points out. “Virtually
all Danish mortgage bonds have AAA credit ratings from
foreign rating agencies” he adds. In contrast to countries
where homeowners borrow more than 100% of a property’s
value, loan to value ratios in Denmark are capped at 80%
at inception, and most are now much lower due to home
price appreciation.
There is abundant local demand for mortgage debt. Fixed
income is the bread and butter of saving in Denmark,
which is a much less equity oriented economy and society
than is Sweden. There is also some demand from overseas.
Though only Euro-denominated Danish debt is eligible for
ECB purchases, Danish mortgage bonds have benefitted
from substitution effects owing to their yield premium.
US and German investors have been attracted to Danish
mortgage bonds that have offered higher interest rates
– usually measured as Option Adjusted Spreads (OAS) –
than have other bonds such as German ones.
OAS adjust for borrowers’ embedded call option. In
common with US mortgages, borrowers have the potential
to pre-pay or refinance loans, in part or in full, prior to
maturity. This is locally described as “redemptions”.
Nielsen views this call option as beneficial to the overall
system. This prepayment risk is probably far more relevant
than credit risk for these bonds. Indeed, “callable bonds
can trade at the highest spreads, of 2% or so for a 30
year bond” says Nielsen. Such callable bonds are trading
at a price of 97 or 98, but the vast majority of the
Danish market now trades above par, making it vital to
get comfortable with prepayment risk. Investors owning
bonds above par could incur capital losses if prepayments
or re-financings occur at par (and these losses could be
multiplied for leveraged strategies). There are apparently
enormous incentives to refinance given that some older
mortgage loans have interest rates as high as 5-6%! Yet
prepayments in the Danish market have been relatively
subdued. Many borrowers have not refinanced because
doing so can entail prohibitively high transaction costs for
some older bonds, Nielsen has found.
For some investors, Denmark’s currency is the icing on
the cake. The Danish Krone’s peg to the Euro is seen as

something of a “one way bet”. Investors remain confident in
the peg holding but also think that, if the single European
currency did break up into two or more units, the Danish
Krone would be pegged to a stronger, mainly Northern
European, bloc (which might include countries such as
Germany, Austria, the Netherlands, and Finland) – and
would therefore appreciate in value.
Regulatory Risk in 2008, 2015 and in
future?
Despite all its attractions, the Danish mortgage market
has not always gone up in a straight line. Nielsen recalls
how in 2008 there were serious problems when lower
interest rates increased liabilities for pension funds, and
forced them to sell Danish mortgage bonds. According to
Nielsen, “investors used Danish mortgages as a source of
liquidity because other government bond markets were
frozen in late 2008”. Subsequent issuance of 30 year
Danish Government bonds has now satisfied the pension
funds’ appetite, Nielsen reckons. More recently, 2015 saw
another jitter with regulations the culprit once again. But
this time around it was Danish banks that were selling.
The banks had also encouraged borrowers to shift from
one year adjustable rate mortgages to longer term loans
with interest rates re-set at two, three, four or five year
intervals. When local mortgage spreads widened, HP’s
hedge fund had its worst ever year in 2008 (down 27.53%)
and saw a small loss in 2015 (of 1.69%).The fund bounced
back strongly after these drawdowns, making 54.24% in
2009 and it is up 8.5% in 2016 to July. Nielsen is aware
that new, international, banking capital and solvency
regulations, such as Basel III, could make life somewhat
more difficult for Danish mortgage lenders, though he is
not sure on the timing or quantum of any impact.
The HP Strategies
HP Hedge runs around 7 billion DKK in their long only
strategy, and roughly 450 million DKK in the hedge fund
strategy. Nielsen envisages more capacity exists for the
hedge fund strategy but does not want to get too big, for
risk management reasons, - so that “we can cut risk when
and if we need to”. The master fund is denominated in
DKK and HP Hedge has launched a Swedish Krone (SEK)
feeder fund that is hedged using a currency swap. The
DKK fund can be bought by retail or professional investors
in Denmark while the SEK fund is currently only available
to professional investors in Sweden.
HP’s hedge fund strategy is primarily a “carry trade”
approach that levers up the interest rate spread between
its funding costs, based broadly on government yields, and
its income, based mainly on mortgage bond yields. Local
bank Nordea provides leverage (and is also custodian and
depositary). The fund’s financing costs are based on repo

rates, which are currently negative, and the fund’s cost of
leverage is negative. Meanwhile, its assets earn between
0.25% and 2%, resulting in a spread ranging from at least
0.25% to 2.00%. The leverage, which has typically been in
a range of 4.5 to 6.5 times, (and has never hit the maximum
permitted level of 11 times) multiplies the spread up to a
gross return that is intended to give investors net returns
of at least 5-6%, after costs.
Since inception in 2007, the fund has annualised at 8.93%.
The fund has exceeded its return target for much of the
post-crisis period, often by a factor of two or three or more,
and HP Invest has won performance awards. Returns have
surpassed the target thanks to the tightening of Danish
mortgage bond spreads, and the very low level of borrowing
costs. At the macro level, the fund aims to hedge interest
rate risk, mainly through shorting German government
Bunds and Schatz, and using DKK swaps (though options
can also be used to hedge interest rate risk).
As well as spread compression, the strategy has benefitted
from the fact that realised prepayments have turned out to
be lower than anticipated. Clearly, if spreads widened and/
or prepayments exceeded expectations, returns might suffer.
In some respects HP seems rather plain vanilla compared
with some other mortgage hedge funds. On the long
side HP buys bonds backed by whole loans. It does not
trade mortgage derivatives, such as IO (Interest Only) or
PO (Principal Only) strips. Nor does it invest in structured
credit vehicles, such as CMOs (Collateralised Mortgage
Obligations). HP buys shorter duration bonds and buys
“the safest bonds which are immensely secure” Nielsen
claims. The fund is administered by Nykredit Bank A/S
subsidiary, Nykredit Portefølje Administration A/S, which
marks the portfolio to market prices. “We have not had
any marked to model assets historically” confirms Nielsen.
HP is not completely restricted to residential mortgages
however. HP can also allocate to bonds issued by Ship
finance, which are perceived to be part of the Danish
mortgage market – but pay higher yields than mortgages
partly because the Ship finance bonds have a lower credit
rating, around single A.

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