The Danish callable bonds index has underperformed “govies” and swaps so far this year as higher rates in 1H21 transformed significant negative convexity into duration that the market struggled to absorb. We believe these fixed-rate bonds, comparable with U.S. Agency MBS with a call option at par, currently have an attractive carry return profile relative to much of the AAA bond universe.
With an outstanding equivalent of around €390 billion (DKK 2,905 billion), the Danish covered bond market is the largest in Europe. DKK-denominated and AAA rated by Standard & Poor’s, the callable bond market is the second-largest covered bond segment in Denmark, comprising mainly 20-year and 30-year fixed-rate bonds with coupons from -0.5% to 5%. Due to a passthrough structure, bond cash flows mirror repayments from the underlying loans. Borrowers also may exercise their prepayment option at par with no penalty by giving the mortgage bank notice of prepayment. This model is similar to that of U.S. Agency MBS.
This year, in addition to negative convexity, the asset class was hindered by volatility in rates, due to concerns about inflation and its implication for monetary policy, coupled with uncertainties on growth, stemming from new waves of COVID-19.
However, we see various reasons to be positive on Danish callable bonds:
- The segment’s option-adjusted spread is currently at a high, with the index OAS to Danish government bonds at around 75 basis points (i.e., at around 100 bps of pick-up versus German yields), which we believe is attractive for a “safe” AAA rated asset class.
- Net issuance of callable bonds should be lower moving forward: (1) The Danish central bank expects housing price appreciation to stabilize, from 13% in 2021 to 3% for 2022, and rates have been low over the last few years, leading to many prepayments. About 70% of all callable bonds have a coupon of 0.5% or 1%, and 87% of all borrowers are paying 1.5% or below on their 30-year mortgage. Therefore, in our view, the majority of Danish borrowers will not prepay their mortgages unless a new 0% 30-year mortgage is introduced. (2) A steeper yield curve should push some borrowers into five-year covered bond bullets. (3) Total turnover in the housing market is slowing.
- The Danish krone has strengthened recently, even after the first interest rate cut by the Danish central bank in early October. A second cut is expected by year-end and should provide another support for callable bonds, especially for foreign investors. For us, the current callable index return looks attractive at around 2.3% hedged in Japanese yen and 2.8% hedged in U.S. dollars on a three-month horizon.