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World's biggest covered-bond market tests extreme rate territory

[COPENHAGEN] Half a decade after rates first went negative in Denmark, the country is continuing to test records in ultra-low borrowing costs.

The latest example is in Denmark's US$470 billion mortgage-backed covered-bond market, the world's biggest. Interest rates are now so low that Danish households can lock in to mortgage rates of 1.5 pe rcent for 30 years. By comparison, the government of the US pays a 2.75 per cent coupon on its benchmark 30-year bond.

The prospect of lower rates in Denmark's April refinancing quarter has Nordea Bank predicting that households will want to switch up to 40 billion kroner (S$8.58 billion) into mortgages with lower interest rates. In 2017, quarterly prepayments ranged from 20 billion kroner to 32 billion kroner.

Danish bond markets have been anchored by the central bank's mostly negative benchmark rate since mid-2012. The bank, which uses monetary policy to defend its euro peg, probably won't raise rates at all this year, according to Nykredit. Nordea estimated last year Danish rates will probably stay negative well into 2020, even as other central banks start winding back their extreme stimulus policies.

Frederik Nordsborg, head of rates research at Nordea in Denmark, says the extreme demand for yield is pushing rates down on callable mortgage bonds to a degree that raises questions as to whether the call option incorporated into the bonds is correctly priced.

"The special thing about Danish callables is that the risk premium is not reflecting credit or liquidity, but instead reflects the fundamentally different bond structures," Mr Nordsborg said.

"The callability of the bond implies negative convexity, which investors should be compensated for in terms of higher carry, compared to non-callable bonds. The big discussion is whether this is priced fairly after the recent massive performance."

For now, Mr Nordsborg says Nordea's data suggests foreign demand for the bonds is still very strong, which doesn't surprise him. "I'm long on Danish callables, even despite their recent performance," he said.

"The dominating factors this year are more hunt for yield, a lot of cash and more foreign investors, just as it was in 2017," Mr Nordsborg said.

For the domestic market, the risk is a sudden change in sentiment from offshore investors. "We have to understand what the drivers are for when foreigners enter the market and, not least, when they exit. And this is a key concern for everyone in the Danish market," he said.

The History

Danish mortgage banks were briefly able to offer 1.5 per cent 30-year mortgages in 2015, after a speculative attack against the krone forced Denmark's central bank to cut its main rate to minus 0.75 per cent, switch off bond sales and build up record foreign reserves. That mortgage product was only on offer for a short while, though, with 1.5 per cent proving unsustainable at the time.

Denmark's extremely low rates have also made it easier for households to keep up with debt payments, resulting in historically small loan losses at banks. But new accounting rules (so-called IFRS 9 standards) may change that picture slightly. The central bank said on Tuesday that Denmark's biggest lenders are likely to report bigger loan losses in the first quarter, citing a survey.