In this Covered Bond Market Insights report, S&P Global Ratings presents the local covered bond market, explains how the relevant legal framework works, provides an overview on the local mortgage market, and compares key characteristics of the existing programs.

In our view, stable ratings and outlooks and a strong sovereign will continue to support ratings stability for Danish covered bonds despite the COVID-19 pandemic.

S&P Global Ratings acknowledges a high degree of uncertainty about the evolution of the coronavirus pandemic. The current consensus among health experts is that COVID-19 will remain a threat until a vaccine or effective treatment becomes widely available, which could be around mid-2021. We are using this assumption in assessing the economic and credit implications associated with the pandemic (see our research here: www.spglobal.com/ratings). As the situation evolves, we will update our assumptions and estimates accordingly.

Overview: Denmark, A Small Giant

Denmark has one of Europe's longest-running traditions of using secured mortgage bonds to fund property purchases. This system has deep roots in the Danish financial system, and historically, Danish banks, insurers, and pension funds have supported strong demand for the covered bond product.

Today, Denmark is the largest covered bond market in the world, with outstanding issuance totaling €419 billion (approximately 133% of GDP) at the end of 2019. However, euro-denominated benchmark covered bond issuance remains niche, and euro-denominated supply has been negative since 2016 (see chart 1).

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Government stimulus following COVID-19

Following the COVID-19 outbreak, the Danish government introduced emergency support policy measures to help the economy, which amounted to about 17% of GDP or Danish krone (DKK)400 billion, which includes up to DKK100 billion of guarantees to companies, DKK150 billion in deferral of value-added tax and tax payments, as well as increased government spending of up to DKK150 billion. Further, Danish covered bond issuers indirectly benefit from eurozone monetary stimulus.

European covered bond framework under implementation

The Danish covered bond law has developed significantly since its introduction, but the Danish legal covered bond framework will likely need further adjustments to align with the new EU harmonization directive (see "Harmonization Accomplished: A New European Covered Bond Framework," published on April 18, 2019). While Denmark's soft-bullet system is compatible with the directive's 180-day liquidity requirements, legislators will likely need to introduce a nominal minimum level of overcollateralization, as the law's overcollateralization standards currently require 8% of risk-weighted assets. The status of non-grandfathered Realkredit Obligationer under the new regulation is also unclear, and questions remain on how limits on bank exposures will affect the current derivative setups.

COVID-19 tightens its grip on Europe's mortgage markets

We expect the impact of the pandemic, particularly on the economy, will affect house prices in nearly all European markets this year. As of 2017, Denmark's house prices have mostly recovered following a significant correction during the 2008-2012 financial crisis. Households have been deleveraging and increasingly moving to fixed-rate mortgages over the past few years, thereby reducing their sensitivity to interest rate hikes. Even so, Denmark's ratio of bank credit to the resident private sector is the highest among European peers, despite gross household debt to disposable income falling to about 234% at year-end 2018 from the 2009 peak of 270%. Household savings, although substantial, are largely invested in pension assets and residential real estate, which might not be easy to liquidate during times of stress.

Despite the COVID-19 headwinds, we expect house prices to continue experiencing moderate growth in 2020 and 2021. Danish covered bonds are supported by a strong local investor base and a growing foreign investor base. Euro-denominated issuance depends on the price of derivatives, and it is less attractive compared to domestic issuance in the current low interest rate environment. At the same time, foreign investor appetite for DKK-denominated covered bonds has increased, supported by positive yields, making issuers less dependent on euro-denominated bonds (see chart 3).

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The Covered Bond Framework: Uniquely Different

Legal framework

Different acts regulate Danish covered bonds, depending on whether the issuer is a mortgage bank or a universal bank: The Danish Mortgage-Credit Loans and Mortgage-Credit Bond etc. Act regulate the former, and The Danish Financial Business Act regulates the latter. Complementary regulation and executive orders regulate other covered bond aspects. The current acts came into force in 2007 and have been amended on several occasions.

All Danish covered bonds are secured by mortgage assets included in a capital center or register, which is the equivalent of a cover pool of assets. The Danish Financial Supervisory Authority (DFSA) permits only one type of asset and one Danish covered bond type per capital center or cover pool. Investors in covered bonds backed by a capital center have a preferential right over the assets registered in the specific capital center. If the issuer defaults, an administrator is appointed to manage the capital centers on a standalone basis.

Covered bond issuers may have a number of capital centers or registers, and we analyze capital centers individually and assign ratings independent of our ratings analysis of the issuer's other capital centers.

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Table 1

Key features of the Danish domestic DKK-denominated covered bond market include the tap issuance format and the continued matching of the covered bond to mortgage loan characteristics. Bonds are issued in an auction format and prices agreed before the bond is issued.

Prepayment and mortgage loan refinance rates are important elements of the Danish covered bond market for borrowers as well as investors. The traditional 30-year fixed-rate mortgage allows borrowers to prepay at par value and take advantage of conversion to a loan with lower interest rates. While interest-only bonds now match the full loan maturity, adjustable-rate mortgages are normally funded by bonds with a maturity date matching the borrower's fixed interest period.

Overcollateralization, balance principle, and liquidity tests

The Danish Mortgage Credit Act requires mortgage banks to set aside 8% of their risk-weighted assets as reserves. This would have equated to a nominal minimum of about 4% overcollateralization under Basel rules before the introduction of the internal ratings-based (IRB) models. However, the IRB models have changed both risk weightings and thereby the minimum regulatory requirements.

Due to the balance principle and the tradition of matching mortgage characteristics to covered bonds, overcollateralization for mortgage banks consists of holding securities in a reserve fund. The reserve fund often comprises covered bonds and includes the capital center's own covered bonds, other Danish covered bonds, or highly liquid bonds, as opposed to mortgages. Issuers holding their "own bonds" in the reserve fund remains a key way of creating liquidity in the issuer's own bond series.

The Danish balance principle is a legal requirement that limits mismatches between the terms of the mortgage loans and the bonds that fund them. The principle requires assets and liabilities to match, and many issuers simply match the characteristics of the covered bonds to those of the underlying assets ("matched funding"). Further, the balance principle defines limits on Danish covered bond issuers' market risk exposure to currency and interest rate risk.

The balance principle supports our analysis of the capital center's cash flows as matched, not just in terms of its interest rate and currency characteristics, but also in terms of amortization and principal payments.

Borrower payments reduce the amount of outstanding matching bonds, which are either repurchased or called by the issuer. As the balance principle reduces market risk, this has resulted in lower-than-average target credit enhancement levels for Danish matched funded covered bonds (see "The Danish Covered Bond Market Explained," published July 15, 2014).

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Mortgage Market Overview: COVID-19 Pushes GDP Down But House Prices Remain Resilient

Economic growth at risk

Due to the pandemic, we lowered our expectations for the Danish economy. We anticipate that the country's real GDP will decline by 5.2% in 2020, before recovering by 3.5% in 2021. The government has implemented a comprehensive package of emergency measures to shield businesses and employees from the temporary-but-severe liquidity shock. Direct and indirect government support frameworks extended to the economy so far have amounted to about 17% of GDP or DKK400 billion, which includes up to DKK100 billion of guarantees to companies, DKK150 billion in deferral of value-added tax and tax payments, as well as increased government spending of up to DKK150 billion. We do not expect these measures to be fully utilized; however, we do not exclude the possibility that the government may add further support measures or adjustments to the current measures to ease beneficiaries' access.

We raised our unemployment forecasts for this year and next year. We expect unemployment to increase this year to 6.5% and 5.8% in 2021. Afterward, we anticipate a 5.1% rate for both 2022 and 2023, in line with levels seen before the pandemic. Still, according to our forecasts for 2021-2023, Denmark would have a lower unemployment rate compared to peer countries such as Belgium or France.

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In 2019, national house-price growth was lower compared to the annual increases in previous years, with an average of 3% to 4%. We expect current pressure on the Danish economy to have only a limited effect on house prices despite the impact of the pandemic.

Features Of Danish Covered Pools

While most capital centers are fairly homogeneous, the Danish covered bond market comprises covered bonds backed by a mix of mortgage assets: residential, commercial, multifamily, agriculture mortgage loans, and public sector guaranteed debt. Issuers are not limited by a single covered bond program (or capital center) but may manage several active as well as inactive capital centers.

Currently, most capital centers with active issuance of covered bonds are backed by a mix of two types of collateral: residential mortgage-backed and commercial mortgage-backed covered bonds. We analyze multifamily and cooperative associations and subsidized housing properties by applying our commercial real estate or public sector criteria respectively (see "Related Criteria").

Residential mortgage loans

The majority of Danish residential mortgage loans are secured by single-family homes. The initial loan maturity is typically 30 years, and the level of amortization and availability of interest-only options depend on the borrowers' income and loan-to-value (LTV) ratio.

Historically, mortgage loans have shorter observed maturity dates due to Danish borrowers' appetite for mortgage loan conversion, resulting in observed volatile prepayment rates. We consider a constant prepayment rate (CPR), an input in our asset-liability mismatch analysis, of 5% for mortgage loans in Denmark. We will continue to monitor the market and adjust CPR levels in line with market trends.

Subsidized housing  Historically, a large part of the Danish property stock has been supported in some part by the public sector and is managed by nonprofit associations. Due to guarantees, these loans have comparably high LTVs. Recently, the law has changed how Danish subsidized housing is funded and now requires issuers to maintain specific separate cover pools for mortgages guaranteed by municipalities or the state. We analyze their credit risk by applying our public sector criteria (see "S&P Global Ratings Clarifies Its Approach To Analyzing Danish Subsidized Housing," published on Jan. 15, 2019).

Commercial real estate loans

Commercial properties eligible for Danish cover pools vary significantly and consist of assets such as office space, retail facilities, industrial space, agricultural properties, and windmills. The largest commercial segment is often cooperative housing associations and multifamily housing.

Agriculture loans

Agriculture loans are relatively diverse, ranging from loans to private individuals in the countryside to large commercial agriculture properties. Although the Danish agricultural sector has experienced a challenging business environment, it remains heavily subsidized by the EU, and comprises a notable source of cover pool collateral (see chart 9). We normally treat mortgage loans secured on agricultural properties similar to commercial real estate, in line with our CRE criteria. For agricultural properties for which the household generates most of its income outside the agricultural property, we apply an approach similar to that we use for residential loans.

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Green covered bonds emerge

A potential new source for issuance growth is green covered bonds. Nykredit helped pave the way for green covered bonds, while Realkredit Danmark and Nordea since followed suit (see "Are Covered Bonds Becoming More Sustainable?" published Sept. 6, 2019). This is in part due to the perceived advantageous funding conditions for green and social covered bonds but, more importantly, issuers state that there's interest from both borrowers and investors. The green covered bond market remains limited in size, but with increasing local covered bond investor interest, we expect Danish covered bond issuers to continue to meet the demand.

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Ratings Outlook: Danish Covered Bonds Remain Well Protected From The Risk Of Bank Downgrades

Charts 11 and 12 show that the majority of Danish covered bond issuers are assigned high issuer credit ratings (ICRs). These allow most rated issuers to reach the 'AAA' rating for their covered bonds based on jurisdictional support alone.

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Chart 13 shows the breakdown of the average target credit enhancement levels compared to available credit enhancement across countries. We define the target credit enhancement as the overcollateralization commensurate with the maximum collateral-based uplift.

Danish programs on average have lower credit and market risk compared to peer countries. Consequently, the available credit enhancement is also lower relative to peer countries.

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Scenario Analysis: Danish Covered Bonds Can Withstand Substantial House-Price Corrections

We recently revised our guidance for analyzing residential mortgage loans in Denmark. We do not expect the revised guidance to affect our covered bond ratings (see "Guidance: Global Methodology And Assumptions: Assessing Pools Of Residential Loans," published Jan. 25, 2019). In our last covered bond market insight report on Denmark, we performed a scenario analysis in which we applied considerable drops in house prices (20% and 30% lower) and saw no rating impact (see "Danish Covered Bond Market Insights 2019," published on July 12, 2019). We expect no rating impact if we were to model similar declines in house prices when applying the new guidance.

Related Transaction Updates

• Transaction Update: Nykredit Realkredit A/S General Capital Center Mortgage Covered Bonds, July 9, 2020
• Transaction Update: Nykredit Realkredit A/S (Capital Center C Mortgage Covered Bonds), July 8, 2020
• Transaction Update: Nykredit Realkredit A/S (Capital Center D Mortgage Covered Bonds, July 8, 2020
• Transaction Update: Nykredit Realkredit A/S (Capital Center G Mortgage Covered Bonds), July 8, 2020
• Transaction Update: Nykredit Realkredit A/S (Capital Center I Mortgage Covered Bonds), July 8, 2020
• Transaction Update: Jyske Realkredit A/S (Capital Center E Mortgage Covered Bonds), July 8, 2020
• Transaction Update: Nykredit Realkredit A/S Capital Center E (Mortgage Covered Bonds Program), July 8, 2020
• Transaction Update: Nykredit Realkredit A/S (Capital Center H Mortgage Covered Bonds), July 8, 2020
• Transaction Update: Realkredit Danmark A/S (Capital Center T Covered Bond Program), July 2, 2020
• Transaction Update: Nordea Kredit Realkredit A/S (Capital Center 2 Mortgage Covered Bonds), May 19, 2020
• Transaction Update: Nordea Kredit Realkredit A/S Capital Centre 1's Mortgage Covered Bonds, May 11, 2020
• Transaction Update: Danske Bank A/S (Cover Pool D Mortgage Covered Bonds), March 19, 2020
• Transaction Update: Danske Bank A/S (Cover Pool I Mortgage Covered Bonds), March 19, 2020
• Transaction Update: DLR Kredit A/S Capital Center B (Mortgage Covered Bonds), March 19, 2020
• Transaction Update: Danske Bank A/S (Cover Pool C Mortgage Covered Bonds), Feb. 6, 2020
• Transaction Update: Realkredit Danmark A/S (Capital Center S Mortgage Covered Bond Program), Dec. 19, 2019
• Transaction Update: Totalkredit A/S Capital Center C Mortgage Covered Bond Program, Dec. 3, 2019

Related Criteria

• Global Methodology And Assumptions: Assessing Pools Of Residential Loans, Jan. 25, 2019
• Covered Bond Ratings Framework: Methodology And Assumptions, June 30, 2015
• Methodology And Assumptions: Analyzing European Commercial Real Estate Collateral In European Covered Bonds, March 31, 2015
• Methodology And Assumptions For Assessing Portfolios Of International Public Sector And Other Debt Obligations Backing Covered Bonds And Structured Finance Securities, Dec. 9, 2014
• Covered Bonds Criteria, Dec. 9, 2014

Related Research

• Global Covered Bond Insights Q3 2020, Sept. 17, 2020
• Global Covered Bond Characteristics And Rating Summary Q3 2020, Sept. 17, 2020
• Swedish Covered Bond Market Insights 2020, Sept. 11, 2020
• Denmark 'AAA/A-1+' Ratings Affirmed; Outlook Remains Stable, Aug. 28, 2020
• Banking Industry Country Risk Assessment: Denmark, Aug. 27, 2020
• German Covered Bond Market Insights, July 20, 2020
• How COVID-19 Will Change Covered Bonds, July 8, 2020
• Government Job Support Will Stem European Housing Market Price Falls, May 15, 2020
• European Economic Snapshots: Larger Risks To Growth Loom Ahead, May 5, 2020
• French Covered Bond Market Insights, Feb. 18, 2020
• Spanish Covered Bond Market Insights, Jan. 29, 2020
• Dutch Covered Bond Market Insights, Nov. 21, 2019
• Are Covered Bonds Becoming More Sustainable?, Sept. 6, 2019
• S&P Global Ratings' Covered Bonds Primer, June 20, 2019
• Glossary Of Covered Bond Terms, April 27, 2018
• Harmonization Accomplished: A New European Covered Bond Framework, April 18, 2019
• S&P Global Ratings Clarifies Its Approach To Analyzing Danish Subsidized Housing, Jan. 15, 2019
• The Danish Mortgage Sector Solved The Immediate Problem Of Interest-Only Mortgages, But Remains Vulnerable To Housing Slumps, Sept. 12, 2017
• Denmark's Covered Bond Market Holds Steady In The Face Of Negative Mortgage Rates, Feb. 27, 2015
• Denmark's Section 15 Bond Ratings Remain Exposed To Market Uncertainties, Nov. 17, 2014
• Credit FAQ: The Danish Covered Bond Market Explained, July 15, 2014
• Danish Legislative Changes To Address Refinance Risk Are Credit Neutral For Covered Bonds, Nov. 7, 2013
• Why Interest-Only Loans Could Still Destabilize Denmark's Mortgage Market, Oct. 31, 2013