The Biggest Covered-Bond Market Has a Note Too Complex for Some

(Bloomberg) -- Foreign investors piling into the world’s largest covered-bond market are steering clear of one product.

Banks in Denmark’s $500 billion mortgage-backed bond market last week held the biggest ever auction of so-called floating-rate notes. Foreign investors, who have been bulk buying fixed-rate callable Danish mortgage bonds of late, were conspicuously absent from the floater auctions.

“We didn’t see any foreign investors at the auctions,” Jan Weber Ostergaard, a fixed-income research analyst at Danske Bank A/S, said. “There are a lot of small things that, when you add it up, it’s just not that attractive for foreign investors.” He says the main obstacle is probably just that floating rate bonds “are a bit complex.”

Foreign investors have hoovered up more than a fifth of Denmark’s AAA-rated mortgage-backed covered-bond market, with Japanese pension funds leading the buying spree. Foreigners recently raised their holdings of fixed-rate 30-year securities, which borrowers can redeem, to a record 29 percent.

Jacob Skinhoj, head of fixed-income research at Nykredit, Denmark’s biggest mortgage bank, says foreigners probably will hold about 10 percent of the country’s floater market once the latest auctions are over.

Danish banks began issuing floaters in significant amounts in 2015, as a response to negative interest rates. After the Swiss central bank dropped its currency cap to the euro that year, speculators bet Denmark might be next. The Danish peg held but the central bank cut rates well below zero. Short-term mortgage-bond yields followed, so banks stopped issuing them and started selling floaters instead.

Denmark Slashes Inflation Outlook Despite Negative Rate Record

Skinhoj says foreign investors prefer the higher yield they get on fixed-rate, callable bonds. The callable feature -- meaning investors risk losing the cash flow if borrowers redeem the bond -- was once considered a burden. But with the hunt for yield raising investor tolerance levels, more money has poured into the products.

Floating-rate notes are also redeemed quarterly. They tend to have maturities of up to five years with interest rates that swing with the money market. Some banks issue at par plus a premium, but the bonds can be called at par. According to Oestergaard at Danske, that can be confusing to foreigners. Offshore investors want to know, “How can you issue a bond at a higher price than the borrower can call the loan?”

It’s worth noting that issuance of floaters in the rest of Europe is on track to beat last year’s record, as companies and investors brace for higher interest rates. Data compiled by Bloomberg shows offerings this year may exceed $600 billion.

European offerings of floating-rate notes are on the rise

Issue Date        2018    2017    2016    2015    2014    2013    2012
Total     EU279b EU479b EU306b EU252b EU238b EU127b EU113b
Source:Bloomberg

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