By David van Bragt, Senior Consultant Investment Solutions at Aegon Asset Management and Nicolas Caplain, Head of Fund Selection at La Banque Postale Asset Management.
Many institutional investors are currently attracted by the potential for high yields on mortgage investments. Exposure to the mortgage market can be achieved in various ways, such as through a pool of mortgage loans or by investing in repackaged mortgage-backed securities. An interesting alternative approach is used in Denmark: in this country, mortgage loans are coupled to mortgage bonds that have a very high rating and can be traded in a liquid secondary market. In this article, we compare Danish mortgage bonds with direct investments in Dutch mortgage loans. This analysis informs institutional investors about the distinguishing features of these mortgage markets.
The general characteristics of the Dutch and Danish mortgage market are quite similar: both markets are large, well developed and supported by households with (on average) a high net worth. The following distinction is particularly important, however:
- Dutch mortgages are direct loans. They are accessible via funds, special purpose vehicles (SPVs) or separate mandates. Investments are typically made via a pool of thousands of mortgages. The total size of the Dutch mortgage market is around €669 billion.
- Danish mortgage bonds are listed bond issues, whose notional and coupon reflect the notional and coupon of a pool of similar mortgages on a pass-through basis. They can be directly accessible via an investment in listed bonds, or via fund structures. The market for Danish mortgage bonds (around €363 billion) is one of the largest covered bond markets in the world.
A global comparison of Danish and Dutch mortgage investments is provided in Table 1:
We discuss the different criteria in this table in more detail below.
Figure 1 shows that Danish mortgage bonds currently offer a spread of ≈ 1.3% over Danish government bonds, mainly as a compensation for the embedded options in the mortgage bonds. The rate on new (long-term) Danish and Dutch mortgages is currently ≈ 1.0% higher than for Danish mortgage bonds. This is mainly a compensation for the less liquid direct mortgage loans, compared to the liquid Danish mortgage bonds.
Danish mortgage bonds have the advantage of being more liquid than Dutch mortgages. Their underlying financial instruments are bonds traded on an active secondary market.
Danish mortgage bonds and Dutch mortgages both require a limited amount of capital under Solvency II, with an edge for Dutch mortgages due to larger diversification benefits.
Interest rate hedge:
Dutch mortgages are less complex in terms of embedded options, in particular when considering the higher prepayment risk of Danish mortgages. Prepayment is possible without a penalty for Danish mortgages which are linked to callable mortgage bonds. In this case, the bond will be called (at par) with a higher probability at a lower interest rate level. This makes Danish mortgage bonds less suitable for hedging the interest rate risk of long-term liabilities.
In the Netherlands, a large mortgage insurance structure is in place: the “Nationale Hypotheekgarantie” (NHG). A Dutch NHG mortgage loan can be considered to be government-guaranteed. In Denmark, mortgage insurance structures do not exist.
Danish mortgage bonds are mostly denominated in Danish kroner. For euro investors, the currency risk is limited when investing in Danish mortgage bonds because the Danish krone is pegged to the euro.
Based on our analysis, we conclude that Danish mortgage bonds may be an attractive alternative to Danish government bonds (higher yield, high liquidity, low capital charge). For investors who allocate part of their assets to illiquid categories, Dutch mortgages can offer an additional spread compared to Danish mortgage bonds. The Dutch mortgage product is also less complex in terms of embedded options, in particular with respect to prepayment risk which may manifest itself in case of decreasing interest rates.