Danish Bonds Endangered by Foreign Investors?

Because the influx of foreign investors has enabled Danish adjustable-rate mortgages to adjust interest rates downward—and thus avoid a foreclosure disaster in the wake of the housing bubble collapse—the Danes, who have an extremely high level of personal debt compared to other European countries, have opted to rely on those adjustable-rate mortgages to get through the crisis rather than sticking with longer-term fixed-rate mortgages. That’s been highly beneficial, since they can take advantage of each drop in interest rates, but it’s also a double-edged sword. Since those mortgages adjust every year, they expose mortgage holders to the risk of interest rates increasing enough to cause trouble.

As a result, if interest rates were to rise, a great many households could suddenly have a problem keeping up with the payments. That would in turn reduce consumption, throwing the Danish economy a nasty curve. And, since these mortgages reset every year, that means every year there must be enough investors to buy the bonds that finance them.

Fitch analyst Cosme de Montpellier, who is on the covered bond side at the ratings agency, said that although Danish lenders have a large amount of refinancing every year, the annual shift of investors wouldn’t have such an impact if there weren’t so many at the same time. So the trend in Denmark now is toward spreading out the refinancing auctions over four dates during the year, rather than holding them all at once. There’s also a move to steer mortgage holders away from the one-year reset product and back toward longer-term fixed mortgages so that the whole market becomes more stable.

And according to Fitch analyst Jens Hallen, on the mortgage bank side, tipping the scale back toward Danish investors holding more of the bonds is “not going to happen until international investors want higher interest rates pushing up yields in Denmark.” The “problem” of too great a proportion of international investors will resolve itself when yield increases in Denmark and its domestic institutional investors return.

While currently the possibility of bank downgrades over the potential for foreign investor flight is “not an imminent threat,” according to Hallen, what will strengthen the position of the two banks is the return to Danish bondholding by its domestic institutional investors—again, once interest rates increase.

In the meantime, that new law mentioned above is a new risk factor that could affect how foreign bondholders feel about their investments. This year the Danish parliament, or Folketing, has passed a law that allows the maturities on those one-year bonds to be extended should there be an auction failure, a dearth of investors, or an increase in interest rates greater than 5%. While that would definitely help in many ways, one risk it introduces is the possibility of flight by foreign investors who could become skittish if suddenly after one year they couldn’t get rid of their bonds.

“If the extension is triggered, the idea is that if interest rates increase too much, the bondholder will have to keep the bond for another year—and it could go on for a second, even a third year if no refinancing is possible. While that may signal a problem in the market and some international investors would try to pull out of Denmark, the law has reduced our liquidity concerns following such an event,” said Hallen.