Liquidity on the Line in Denmark as Rules Splinter Bond Market

  • Danske this week missed a target for a mortgage bond auction
  • More bond series create risk of auction flukes, Danske says

Denmark’s $420 billion covered-bond market is losing liquidity as regulatory reform spurs a proliferation of new products, splitting the market into numerous silos.

The development is already disrupting the market. Earlier this week, prices fell so low in an auction of three-year bonds that the issuer, Danske Bank’s mortgage arm, decided against selling the entire allotted amount. The event probably was a “fluke” but it underscored the risk of continually adding new series of securities to the mix, according to Jens Peter Soerensen, chief analyst at Danske Markets.

“‘There is a lot of talk about how can we make things more liquid,” Soerensen said. “The input to the mortgage banks is: reduce the number of ISIN codes.”

Banks and investors are trying to adapt to a wave of national and European regulations affecting capital, liquidity, trading and securities. But the unintended consequences of a lot of the new rules are just beginning to become apparent.

Realkredit Danmark said on Wednesday it would sell only 70 percent of the 2.72 billion kroner ($390 million) in three-year mortgage-backed covered bonds that it had intended to sell that day. The lender walked away from the auction after prices fell short of expectations.

It was a “first” for the Copenhagen-based mortgage lender, said Christian Rosenstand, head of funding at Realkredit Danmark. He declined to reveal where bids came in and said it’s unclear why they were so low.

Denmark’s mortgage banks hold quarterly auctions to refinance short-term bonds backing mortgages as long as 30 years. In auctions that started this month, lenders will refinance loans of about 200 billion kroner ($29 billion) in total, Sonia Khan, an economist at Realkredit Danmark, said in an Oct. 21 note.

Analysts suggested a variety of reasons for the auction miss on Wednesday, including more competition from smaller rivals and new rules that prohibit banks from filling liquidity buffers with their own securities.

Investors may also be reacting to new Danish rules that require mortgage banks to make provisions in a bond’s offering terms stating what happens if an auction fails. The requirements, passed by parliament last year, means that a practice of using the tail-end of three- and five-year bonds for one-year financing is no longer possible, forcing lenders to issue new notes and leading to further fragmentation of the market.

That means “banks have to open a new ISIN code,” Soerensen said.

It’s worth remembering that yields are still very low and the refinancing auctions now taking place are likely to result in interest rates below 1 percent for one-, three- and five-year bonds, according to Nordea Kredit.

In fact, on Thursday, Realkredit Danmark’s auction of three-year bonds went off without a hitch. With a bid to cover ratio of 4.2, the day’s high, the interest rate was set at 0.36 percent.

“There’s generally been good demand from domestic and foreign buyers,” Soerensen said before the results were released. “A lot of people had been waiting to buy at auction and kept their powder dry.”

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