Danske Caps Covered Bonds to Win Over Senior Creditors

Danske Bank A/S plans to limit issuance of the safest bonds to avoid falling into a collateral trap that threatens to drive senior creditors away and even push funding costs higher.

Denmark’s largest bank, which is struggling to raise profitability to match its five biggest Nordic rivals and reverse credit rating cuts, will cap issuance of covered bonds at current levels, said Steen Blaafalk, head of group treasury. The decision follows growing reliance on the securities after lawmakers first allowed banks outside the mortgage industry to sell covered bonds in 2007.

“We don’t want to jeopardize our senior creditors’ opportunity,” Blaafalk said in an interview from Copenhagen. Covered bonds now make up about 6.5 percent of total funding, he said. “It will stay around there,” he said. “We cannot see that number being double digit, percentage-wise.”

After rising in popularity among investors and issuers during the financial crisis, covered bonds are now coming under scrutiny as banks set aside an increasing share of their collateral to back the notes. That’s depleting security for the remaining creditors and may even hurt issuer ratings.

European Central Bank President Mario Draghi said last week that overuse of the securities could limit access to unsecured funding and introduce new risks into an industry still plagued by the debt crisis. The European Systemic Risk Board, which Draghi chairs, has recommended fuller disclosure and more regulatory scrutiny.

Monitoring Overuse

The Danish Financial Supervisory Authority said it’s monitoring possible overuse of covered bonds.

“Along with other supervisors, the FSA is also currently looking into the possible risks of high levels of asset encumbrance for relevant institutions,” Anders Raun, deputy director at the Copenhagen-based agency, said in an e-mailed response to questions.

Danske has used the bonds to cut its funding costs as Denmark grapples with the fallout of its bail-in legislation. The securities have also helped the bank keep a lid on its capital costs as it targets tripling its return on equity to more than 12 percent by 2015 to compete with Swedish rivals such as Nordea Bank AB.

The bank’s “rule of thumb” for the past three years has been to split debt issuance evenly between covered bonds and senior debt, with some variations, Blaafalk said.

Costs Easing

Covered bonds made up 47 percent of Danske’s long-term debt funding at the end of last year, or 167 billion kroner ($30 billion). Danske plans to cap its reliance on the securities even as the cost of issuing the notes falls.

Last week, the bank sold 1 billion euros ($1.3 billion) in seven-year covered bonds at the best price “we’ve seen in four years,” Blaafalk said. Danske will issue 30 billion kroner to 60 billion kroner in debt this year, compared with as much as 100 billion kroner in some years, he said.

“We accelerated some of our long-term funding last year so we actually have a strong liquidity position today,” he said. “We are ahead of the curve so we don’t need to do much.”

Danske last month repaid 1.5 billion euros tapped from the ECB’s first longer-term refinancing operations and may pay back 4 billion euros borrowed in the second LTRO, Blaafalk said. The decision will depend in part on the market’s response to Italy’s elections, he said.

Ratings Cuts

Danske’s unsecured funding has been dogged by downgrades last year by Moody’s Investors Service and Standard & Poor’s after burst property bubbles in Ireland and Denmark hurt earnings.

The bank’s return on equity was 3.59 percent last quarter, according to data compiled by Bloomberg. That compares with Svenska Handelsbanken AB’s 14 percent.

Danske’s senior unsecured debt maturing Feb. 28, 2017, bears a coupon of 3.875 percent. That compares with a coupon of 3.375 percent for Handelsbanken’s senior unsecured debt maturing in July 2017.

The coupon on Danske’s February 2020 covered bond issued last week is 1.625 percent, compared with 1.875 percent on Handelsbanken’s bond due Oct. 2, 2019. Danske is rated Baa1 at Moody’s, A- at S&P and A at Fitch. Handelsbanken is rated Aa3 at Moody’s and AA- at both S&P and Fitch.

Bank Teams

Investors have snapped up covered bonds from Danish issuers even after the nation was dragged through a housing slump that left property prices more than 20 percent lower since their 2007 peak. To tap demand, commercial banks including Jyske Bank A/S, the country’s second-largest listed lender, teamed up last year with mortgage bank BRFkredit A/S.

Jyske said today it will almost triple mortgage lending funded via BRF. Jyske said it expects to have as much as 8 billion kroner funded by the end of this year, compared with 3 billion in 2012.

Covered bonds’ popularity comes in part because Danish banks maintain strict loan-to-value requirements. New mortgages can’t exceed 80 percent of a property’s value, reducing the risk of foreclosure waves such as those witnessed in the U.S. following its subprime mortgage bubble.

Even though Denmark’s housing market remains a long way off its pre-crisis levels, the average LTV ratio is 55 to 60 percent, Blaafalk said.

“That isn’t something that you find in the rest of Europe,” he said. “You know you don’t get that much yield but you also want to diversify yourself.”

Danske reported a more than fivefold surge in fourth-quarter profit after impairments fell by almost half.

“My pricing in the senior market is reflecting already that the market is expecting Danske Bank will get a rating hike earlier rather than later,” Blaafalk said. “We have to deliver now on stable profit and loss results and to have falling impairments.”

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