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Performance Review 2008
Henrik Stille: "Danish mortgage bonds have underperformed government bonds heavily in 2008. This underperformance comes from the period between September and December when the worldwide credit and financial crisis worsened.
Through the first half of the year, interest rates were moving higher across the curve and the market. In addition, central banks seemed to be more concerned about inflation than any possible impact the financial crisis could have on economic growth.
At the end of August, the sentiment in the market started to change when the impact from the financial crisis appeared far worse than expected. Danish mortgage bonds performed poorly in September and October together with other credit related products. Also, European covered bonds as well as investment grade and high yield bonds performed extremely badly in this period.
At the beginning of the year (January to June 2008), interest rates started to drop and the 2-10 year yield curve had flattened around 100 basis points (bps) due to aggressive rate hikes from the European Central Bank (ECB). Since callable mortgage bonds have most of the yield curve exposure in the far end of the curve, the steeper yield curve had a negative impact on the performance of Danish mortgage bonds.
The Danish yield curve did not steepen as much as the European yield curve during the second half of 2008. This is due to the fact that the Danish central bank runs the Danish crown with a fixed rate relative to the Euro and during the financial crisis the Danish foreign currency reserve came under a lot of pressure. This forced the central bank to hike rates and to widen its spread to the ECB to defend the Danish Crown and keep it in its narrow trading band relative to the Euro. When the liquidity crisis softened in December, the foreign currency reserve strengthened significantly from the rate hikes and the central bank was able to lower its key interest rate and narrow its spread to the ECB.
Looking at the relative value and allocation between the various mortgage segments, the segments that performed worst in 2008 were in general the large benchmark series with a higher percentage of foreign ownership. The 30 year 4% and 5% callable bonds were among the poorest performing segments as well as the long 30 year 5% capped floaters. The callable bonds with higher coupons (6% and 7%) held up better as well as the short 10 year capped floaters and 30 year 6% capped floaters. The more defensive callable bonds such as the 4% and 5% 20 year bonds also managed to perform better within the mortgage segments.”
Performance Review 2009
Henrik Stille: “Danish mortgage bonds had a good performance through 2009 with tighter spreads relative to swaps and government bonds.
Long interest rates (10 years) were rather flat through the year while shorter yields dropped which made the yield curve steepen some 70bps in Denmark. The steeper yield curve caused borrowers to buy back their callable loans in the market and refinance them into short non-callable loans. This was helpful for callable mortgages during the whole year and contributed to a significant part of the spread tightening in Danish mortgages. The ECB was very active in 2009 in the covered bond market in the Euro zone as it bought back significant amounts of covered bonds. The ECB’s buy backs also implicitly supported Danish mortgages.
The Danish central bank lowered its benchmark yield from 1.55% to 1.20% independently from the ECB on several occasions in the second half of 2009. The lower Danish central bank key rates supported especially short Danish mortgages towards the end of the year.
Looking at the relative value and allocation between the various mortgage segments the segments that performed the best in 2008 were the callable 30 year 5% bonds.”
Performance Review 2010 - Year-to-Date
Henrik Stille: “Danish mortgage bonds have had so far in 2010 a neutral to stronger performance than Danish government bonds. Spreads have tightened relative to swaps and are unchanged relative to government bonds for the main callable segments.
5 year yields have dropped by more than 100bps since the beginning of the year while the shorter maturities are down 70 - 80bps. The relatively steep yield curve continues to make it attractive for borrowers to keep their funding in short non-callable loans and therefore we have not seen much new issuance in callable loans.
Long-term callable bonds have been doing very well in 2010, especially in the last months. The good performance is due to lower than expected prepayments in the segment. Capped floaters had a bad start to the year due to speculation about the new Solvency II regulations that could make holdings of bonds with long spread risk to weight heavier on pension funds’ balances. The Solvency II draft was later relaxed and the capped floaters from early May picked up some of the performance they had lost early in the year. Non-callable mortgages so far performed rather neutral relative to government bonds, they lost some performance lately due to speculation about more issuance in the upcoming autumn due to the attractive 3-5 year yields for borrowers.
The Danish central bank lowered its benchmark yield to 1.05% independently from the ECB two times in the first half of 2010 due to steady inflow into the Danish currency reserve.”
Performance since 2008
Investment Process and Strategy – How does the Fund Manager Invest?
The investment strategy applied can be defined as a overlapping bottom-up and top-down approach. The fund manager aims to create alpha by investing in Danish mortgage bonds. The latter, represent a minimum of two thirds of the portfolio. The portfolio manager also diversifies the fund’s portfolio with Danish government bonds.
In the first step of the top-down process, the management team identifies the most attractive risk premiums available in the Danish mortgage bond market with the help of a quantitative assessment of historical data. Based on this data driven analysis the portfolio management evaluates the attractiveness of the main strategies and overall bets. Afterwards, a more detailed analysis is carried out to identify the most attractive bond segment that the portfolio management is expecting to benefit the most. On an individual bond level, the most attractive bets are identified within the relevant bond segments.
Parallel to the described top-down component of the process, each selected bond is analysed from a bottom-up perspective in terms of issuer, prepayment risk and liquidity.
This investment process assures that the investors looking for an attractive investment opportunity in high quality fixed income securities find solid historical performance with a relative low correlation and volatility. The fund offers a long industry track record with no negative return during the last ten calendar years. It offers a relatively unknown solution for those who search for extra returns without meaningful additional risk. Being the oldest and second largest mortgage bond market in Europe, the Danish mortgage bond market is a very stable, robust and efficient system, even during economic downturns. This gives the portfolio manager the opportunity to provide an investment alternative with a potential extra yield compared to government bonds on a mid-term investment horizon.
Henrik Stille: "The Danish mortgage bond market will, going forward, be impacted by several factors both domestically and internationally. Currently, the main callable mortgage segment (5% 30 years) is trading at price 104 and lower yields from here will most likely trigger higher prepayments in these bonds and new issuance in the 4% 30 year callable segment that currently is trading at price 97.50.
The non-callable mortgages are trading at flat to +15 bps relative the Danish swap curve in the 3 - 5 year maturities. This offers a pick up to government bonds of around 70bps. We view this level as being attractive and a relatively safe bet compared to the more volatility that can be expected in the return of the callable mortgages.
Although Danish mortgage bonds performed strongly in 2009 and the potential for further spread tightening in 2010 is more limited, there continues to be many good reasons to remain overweight in Danish mortgage bonds. To start with, the implied volatility in the market is still above its historical average and if volatility continues to normalise this will benefit Danish mortgages. The pick up in carry relative to government bonds is also attractive at current levels and this is also a good reason to be invested in Danish mortgages.
The yield curve is still steep and as long as it stays this way, many borrowers will avoid long callable loans and instead borrow at the short end of the yield curve. However; the joker is the 4% 2041 bonds, a segment that historically has attracted many borrowers when this bond trades close to 100. A 4% 2041 callable bond trading close to 100 might increase the issuance in callable and decrease issuance in non-callable bonds.
We will therefore keep a close eye during the rest of the year at the issuance in callable vs. non-callable mortgages and re-allocate the fund between segments as the issuance pattern changes.”