S&P Cut No Match for Swedish Mortgage Bond Allure

S&P Cut No Match for Swedish Mortgage Bond Allure
A woman cycles past new homes under construction in the coastal area of Vastra Hamnen in central Malmoe. Photographer: Linus Hook/Bloomberg

Swedish bonds tied to mortgages are basking in the country’s haven status, undiminished by the threat of a downgrade from Standard & Poor’s, as investors bet limited supply will add to the debt’s appeal.

The yield spread on benchmark covered bonds issued out of Sweden has eased to its narrowest since 2008 as supply of the notes is seen dropping about 40 percent this year. The AAA rated securities offer higher yields than Sweden’s government debt, adding to their allure as risk-averse investors look for ways to generate better returns.

“The spreads can tighten a bit further,” said Joakim Buddgaard, a fund manager at Svenska Handelsbanken AB in Stockholm, who helps oversee $13.8 billion in fixed-income assets, including Swedish covered bonds. “I’m a buyer, not because I think the spread is going to tighten massively, but because there is still a good pick-up in yields,” he said in an e-mailed reply to questions yesterday.

Sweden’s status as a haven from the debt crisis in the euro area looks set to endure as investors flock to one of only 12 remaining AAA rated countries. The Nordic nation’s success in cutting public debt to about a third the euro-zone average, as a percentage of gross domestic product, has kept investors loyal even as exports stall and companies such as Ericsson AB and Volvo AB cut jobs.

S&P Warning

While Sweden enjoys solid public finances, household debt levels have soared, reaching about 170 percent of disposable incomes, the central bank estimates. S&P lowered its outlook on eight Swedish banks this week, including the biggest covered-bond issuers, Handelsbanken and Swedbank AB, to negative from stable and said Sweden faces “a sharper economic slowdown” and “a build-up of substantial indebtedness for households.”

The euro area debt crisis poses the biggest risk to the country’s financial system, according to a Riksbank survey of bond and currency market participants published today. They see a small likelihood of Swedish households not repaying loans. Though the S&P warning initially sent spreads on Swedish mortgage bonds wider relative to similar-maturity government notes, investors are betting the impact will be short-lived.

The spread between the five-year benchmark mortgage bond sold by Stadshypotek AB -- a unit of Handelsbanken -- and similar-maturity Swedish government notes has narrowed by about 100 basis points this year to 91.4 basis points on Nov. 19, the lowest since July 2008. The spread to swap rates has narrowed to 46 basis points from 116 basis points on Dec. 16, the lowest since August 2008.

Local Buyers

The mortgage notes will be buoyed by a committed domestic investor base as supply declines, according to Charlotte Asgermyr, an analyst at SEB AB in Stockholm.

“If you look at the yield pick-up that Swedish covered bonds still offer toward government” debt, “we expect the domestic Swedish investor base to continue to favor covered bonds in relation to government bonds,” Asgermyr said by phone. “We believe the underlying trend is for tighter spreads.”

Price increases in the securities are likely to resume at the turn of the year, after investors finish closing their positions for 2012, she said.

The premium on mortgage bond yields has fallen as issuance of covered bonds dropped to about 340 billion kronor ($50 billion) up to the end of last month, according to Asgermyr at SEB. Issuance will reach about 380 billion kronor in 2012, down from 620 billion kronor in 2011, she said.

Basel Effect

Swedish bank ratings would face a one-level downgrade in a worse-than-expected economic situation, S&P said. Swedish covered bonds could still withstand another issuer downgrade of 1 to 3 levels before their AAA ratings would be jeopardized, Asgermyr wrote in a note today.

Swedish covered bond issuers had stepped up supply in 2010 and 2011, selling longer-term notes in response to a stable funding requirement set by the Basel Committee on Banking Supervision. Basel has since pushed the deadline back to 2018, giving lenders more time to adjust and easing pressure to sell longer notes.

Norway this year surpassed Sweden as the largest Nordic covered-bond market as measured by the volume of international mortgage-backed bonds outstanding, according to a report by Barclays Plc. Issuance is falling in Europe, with gross supply dropping to 155 billion euros ($198 billion) in 2012 from 247 billion euros, according to a Nov. 16 report by Barclays. New covered bonds will rebound to 175 billion euros in 2013.

Worst Performance

Swedish government bonds have returned 1.57 percent this year, the worst performance among the 26 major Bloomberg/EFFA sovereign indexes. The yield on Sweden’s 10-year note fell one basis point to 1.55 percent while two-year yields were at 0.75 percent. The Swedish OMRX Mortgage Bond Index of benchmark securities has returned 3.68 percent this year.

“Demand has been very strong and continues to be strong,” said Roland Nilsson, chief fixed-income strategist at Swedbank in Stockholm. “It’s secured and you get a yield pick-up versus government bonds, so that’s very appealing.”

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