July 5 (Bloomberg) -- Kim Mikkelsen outperformed his European hedge-fund peers by investing in bonds backed by summer homes in Hornbaek and waterfront apartments in Copenhagen.

Mikkelsen, 38, put about half of his Aaasgard Fixed-Income Fund's $150 million of assets into Denmark's mortgage-bond market, the world's largest per capita. The fund returned 31 percent for the year ended June 29, according to data compiled by Bloomberg, and is No. 1 in HedgeFund Intelligence's ranking of fixed-income hedge funds in Europe.

``It's one of the most exciting niche markets, that offers endless opportunity if you know how to play it,'' said Mikkelsen, chief investment officer for Copenhagen-based Nordic Asset Management, which manages three funds. ``You can't just buy mortgage bonds and sit on them.''

Denmark, with a population of 5.5 million, has Europe's second-biggest mortgage market behind Germany, with 1/15 as many people, says Moody's Investors Service. Danish mortgage lenders can't take deposits, so they sell bonds on every home loan to investors. The result: $312 billion worth of mortgage bonds are traded every year, an amount 13 percent larger than Denmark's 2006 gross domestic product.

Denmark's mortgage bonds yield about 5.5 percent, meaning fund managers have to augment their returns. Mikkelsen, who started trading bonds at age 21 for Copenhagen's Sparsyd Treasury and didn't finish university, magnifies his gains by selling and buying bonds against each other before they mature in a strategy known as fixed-income arbitrage.

Another Danish hedge fund manager, Steen Elverdal, is also profiting on the nation's mortgage-bond market. Everdal, 44, gets around the bonds' relatively low returns by borrowing money from countries with lower interest rates.

No. 2

Elverdal's $135-million fund, HamtonI-Bond 004, returned 17 percent over the last 12 months, according to Bloomberg data, and was No. 2 in HedgeFund Intelligence's European fixed-income hedge fund ranking. The median return for fixed-income hedge funds was 2.6 percent, according to HedgeFund Intelligence.

Mortgage bonds aren't risk-free. Home prices in Denmark increased at an annual rate of 4.7 percent in this year's first quarter, down from 24 percent a year ago, according to the Knight Frank Global Home Price Index. More slowing in Denmark's real estate market could trigger defaults on mortgage bonds.

``You can say the Danish bond market is a safe market,'' said Jens Sorensen, a mortgage-bond specialist at Copenhagen- based Danske Bank. ``But that doesn't means things won't go wrong.''

Subprime Casualties

They have in the U.S., where a $6.5 trillion mortgage-bond market amounts to about half of GDP. A housing slump has pushed up delinquencies on subprime mortgage loans made to homebuyers with poor credit. Bondholders stand to lose as much as $75 billion on securities backed by the mortgages, according to Pacific Investment Management Co.

Casualties include New York-based Bear Stearn Cos., the second-biggest mortgage-bond underwriter. It made an emergency loan last month to save a hedge fund invested in subprime mortgage bonds and may have to bail out a second fund.

Denmark, which set up its first home-funding institution in 1797, two years after the Great Fire destroyed much of Copenhagen, is different, Sorensen said. Danish law, designed to shield mortgage lenders from interest-rate shocks, forces them to sell loans they originate as bonds to investors.

U.S. subprime loans, which can amount to 90 percent or more of a home's value, are often packaged for sale to speculators. In Denmark, the mortgage bondholder is often the homeowner, and loans can't exceed 80 percent of a home's value.

Market Protection

Five out of 10 mortgage banks in Denmark receive top credit ratings, and the rest are a rung or two below that.

One arbitrage strategy that helped Aaasgard was buying so- called capfloaters against other bonds. Denmark introduced capfloaters, adjustable-rate bonds whose interest rates are capped, at the end of 2004. They've been popular partly because mortgage borrowers want protection against rising rates.

``We expected pension funds to buy more of these bonds once the sector became more mature,'' said Mikkelsen. ``In the summer of 2006 we bought Danish capfloaters and hedged them against other types of bonds. That has been a very good trade for us.''

Mikkelsen, who was head of mortgage risk and proprietary trading at SEB Investment Management from 1999 to 2002, minimizes his currency risk by raising and investing money mainly in Danish krone, he said.

Elverdal's fund, managed by Hamton Asset Management, uses so-called gearing to generate gains, borrowing money mainly in Swiss francs and investing in Danish mortgage bonds. The Swiss benchmark rate is 2.5 percent, compared with 4 percent in the euro zone.

High-Priced Neighborhood

Elverdal's fund, registered in the Cayman Islands, has returned about 18 percent since it started in 1997, according to its Web site.

Denmark's home market is cooling, not crashing, according to Knight Frank. This year's gains rank Denmark 22nd among 30 markets tracked by the London-based firm, from No. 2 last year.

A two-bedroom house in Hornbaek, Denmark's equivalent of New York's Hamptons, can cost 15 million krone ($2.7 million). The average price of a Danish home is about $300,000, according to Copenhagen-based Statistics Demark.

One of Denmark's fastest-appreciating markets is Holmen, a district close to the center of Copenhagen that used to be a run- down naval base. Now apartments sell for an average of $720,000; the quarter boasts a new opera house built with donations from U.S. investor Warren Buffett and Danish shipping tycoon Maersk McKinney Moller.

Mikkelsen, a golfer who enjoys Spanish wine, predicts the Danish property market will stabilize after surging for the last three years. ``Since we do not have any subprime loans in Denmark, the credit of mortgages remain among the best in the world,'' he said.

To contact the reporter on this story: Anchalee Worrachate in London at aworrachate@bloomberg.net

Last Updated: July 4, 2007 19:04 EDT