Frits Carlsen is head of business development at Nordea Investment Funds What does the Great Fire o...
Frits Carlsen is head of business development at Nordea Investment Funds
What does the Great Fire of Copenhagen in 1795 have in common with rock-solid investment? The answer is the Danish Mortgage Bond Market.
In view of the likely rise in European interest rates in the near future, fixed-income investors struggle more and more to generate added value for their portfolios. In his presentation, Frits Carlsen outlined the characteristics of the Danish mortgage-backed security market, identifying some if its advantages, particularly in times of increasing interest rates.
Carlsen looked at the history of the Danish Mortgage bond market which was established in 1795 in the aftermath of the above-mentioned blaze.
The Great Fire of Copenhagen wiped out about a third of the city's buildings, so a massive rebuilding scheme was required to replace them. However, the fact there was no reliable finance system presented a huge problem, so the city's residents came up with a new one, thereby laying the foundations for the Danish mortgage backed security market.
As no banks were available or willing to lend money to people who had no money, the system that was created helped to facilitate borrowing. The buyer does not go to the bank but to a credit institution where they are extended a loan of 80% of the face value of the house. The credit institution bundles together all the loans and then issues a very long duration investment bond to the public.
Ever since 1795 this has been the way Danes have been buying their houses, according to Carlsen.
Today, the Danish bond market is divided into government bonds, callable bonds, non-callable bonds and index-linked bonds. The callable or mortgage-backed securities market is the second largest in Europe and is worth e110bn.
The loans are extremely long duration, going up to 30 years, and are currently highly rated by rating agencies. Danish mortgage bonds have been rated since August 1996 and the speed of rating changes increased significantly in 2001/02. Moodys presently gives the sector a 'AAA' rating.
Carlsen explained that people are investing in callable bonds because they offer a high yield pick-up. A typical yield pick-up on a callable bond is around 4.75%, compared with a government bond of 4%. He said this works by the credit institution bundling the loans together, securitising them and issuing a callable bond. The risk of bankruptcy is no higher than 1%.
However, Carlsen warned: "The catch is that the bonds are called callable if the interest rate goes down but then if demand of a bond with high yield goes up, so the price of the bond can go up. This means the house owner has more liability.
"If interest rates go down, however, the homeowner has the option to refinance the loan at a lower rate, which is not good news for the investors of the bond, who are paid a premium high yield to take on that risk."
Carlsen also pointed out that there is no currency risk, as Denmark signed an agreement with the EU Central Bank so that the Danish kroner cannot deviate more than 2.25% from the euro.
If Denmark should join the euro, then there will be a convergence with German bonds, so the investor could have a positive surprise and get additional performance of up to 140 basis points.
Claim from SocGen's global markets division
Third annual Hampton-Alexander review
European Commission yields to pressure
Numbers in Adviserland
Retirement sector trends