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 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.

Overview: Denmark, A Small Giant

Denmark has the largest covered bond market in the world, with outstanding issuance totaling €437 billion (approximately 140% of GDP) at the end of 2020. In 2020, Danish issuers focused on Danish krone (DKK) issuance, which is at a historical high. Euro-denominated benchmark covered bond issuance remains niche, with €0.5 billion issued so far in 2021 (see chart 1). Overall, we expect Danish euro benchmark covered bond issuance to be higher than in 2020 but remain lower than 2019 issuance levels. This is due to continued cheap DKK funding.

According to Finance Danmark, the third quarter of 2021 saw record high gross DKK issuance driven by a high number of homes purchased in the first half year. Furthermore, issuance is shifting into fixed rate bonds with shorter maturities backed by adjustable-rate mortgages. This is driven by the recent increase in interest rates for 30-year fixed-rate loans.

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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. Further, a growing foreign investor base has invested in DKK denominated covered bonds. Euro-denominated issuance depends on the price of derivatives and is generally 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. This is boosting market turnover and liquidity, but also lowering reliance on euro denominated issuance (see chart 3).

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Strong fiscal stimulus following the COVID 19 pandemic

The pandemic has hit the Danish economy less severely than that of many European peers. However, to support the economy during lock down and help recovery after the COVID-19 pandemic, the Danish authorities deployed a sizeable and comprehensive fiscal package. As of May 2021, it had announced measures equal to about 33% 2020 GDP, among the largest in Europe.

In the wake of the COVID-19 outbreak, Danish banks voluntarily offered borrowers experiencing hardships temporary payment holidays. Uptake was limited, and so the offer of support was short lived. Due to the specifics of the Danish covered bond systems, such support was mainly granted on the bank level and did not directly affect mortgage loan performance. It is understood that some borrowers switched to interest only loans to weather uncertainty related to the crisis Direct government support measures in Denmark largely ended at the end of September 2021.

Transposition of European covered bond framework accomplished

On Oct. 23, 2020, the Danish Financial Supervisory Authority published a draft proposal to align Denmark's covered bond laws to the recent EU harmonization directive.

The main proposed amendments to the existing law are the introduction of a minimum nominal overcollateralization (OC) and 180 days' liquidity coverage, and clarification of existing rules for extensions and joint funding. Most existing programs will be grandfathered and only active programs will need to implement the new requirements.

Denmark passed the law in June 2021 and implemented the legislation on July 8, 2021. We expect the legislation will be fully implemented on or before the July 8, 2022, deadline. It remains to be seen if the changes will include opening new capital centers for the issuance of covered bonds.

Danish house prices experienced a minor boom during COVID-19

Following a year of lower house price growth, mortgage market activity and house price growth experienced a significant uptick during the COVID-19 pandemic. Fueled by excess saving, interest in home purchases and summer houses, prices increased by more than 10% year-on-year.

We expect more normal levels of mortgage market activity and house price development in upcoming years.

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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 or 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. The most recent amendments will come into effect on July 8, 2022.

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 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 several capital centers or registers. 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 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 and 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, or reduced debt at a higher interest rate. Adjustable-rate mortgages are normally funded by bonds with a maturity date matching the borrower's fixed interest period; the issuer commits to refinance until the loan matures.

Overcollateralization, extensions, and balance principle

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% OC under Basel rules before the introduction of internal ratings-based (IRB) models. However, the IRB models have changed both risk weightings and thereby the minimum regulatory requirements. Mortgage banks are also required to maintain a debt buffer of 2% of mortgage lending.

To reduce refinancing risk for mortgage banks, covered bonds issued after April 1, 2014 that do not match the maturity of the related mortgage loans may be extended by the issuer or assigned insolvency administrator under certain circumstances. Extensions will occur by 12 months intervals until new bonds can be sold.

The June 2021 amendments to the Danish Mortgage Credit Act introduced a nominal statutory OC requirement of 2%. This does not include the cost of managing a cover pool that is winding down. It also introduced a formal requirement for coverage of 180 days of liquidity needs. The majority of Danish covered bond programs are matched-funded and are exempt from this requirement.

Balancing principle and supervision limits risk

Due to the balance principle and the tradition of matching mortgage characteristics to covered bonds, OC 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.

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 and the bonds' extension features support 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.

As the balance principle reduces market risk, this has resulted in lower-than-average target credit enhancement levels for Danish matched funded covered bonds.

Further, the Danish FSA's "supervisory diamond" set limits on yearly lending growth, interest rate risk, interest only lending to retail customers, short-term funded loans, and large exposures for covered bond issuers.

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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 and 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").

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Green covered bonds and ESG considerations

A potential new source for issuance growth are green covered bonds. Nykredit helped pave the way for green covered bonds, while Realkredit Danmark, Nordea and recently Jyske have since followed suit. This is in part due to the perceived advantageous funding conditions for green and social covered bonds but, more importantly, issuers say there is interest from both borrowers and investors. The green covered bond market remains limited in size. Furthermore, the long-term nature of residential mortgages and the availability of environmental certification has proven a challenge for the issuance of green covered bonds backed by residential mortgages. However, with increasing local covered bond investor interest, we expect Danish covered bond issuers to continue to meet demand.

Environmental and social credit factors are typically credit neutral in our analysis of Danish mortgage covered bonds. We consider social factors to positively affect the rating in Danish programs where assets in the cover pool are loans backed by subsidized housing. These provide affordable housing for the general population and benefit from guarantees from the public sector.

In terms of governance, Danish issuers are not committed to maintain a minimum level of OC. This poses the risk of available credit enhancement potentially decreasing in the future to levels that are not commensurate with the current rating. This reduces the achievable ratings or the number of unused notches available to the covered bond program. On a net basis, we believe the matched funding in most Danish covered bond programs offsets the risk of the lack of a committed OC, while it remains a risk for soft bullet issuers.

The Danish property market: signs of risk build-up during the COVID-19 pandemic

Since the outbreak of the pandemic in 2020, Denmark's house prices have increased by more than 10% year on year, fuelled by low interest rates and high demand. By the end of 2023, house prices are expected to have risen significantly above the level expected before pandemic.

The rise in demand for housing has resulted in a substantially increased property sales, which is at its highest level since the 1980's (see chart 9). According to Danmarks Nationalbank, among first time buyers property sales showed an increase of 17% in 2020, followed by a slight decrease in the first half of 2021.

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So far, increasing house prices and mortgage activity has not led to increases in aggregate housing debt relative to disposable income. Although it decreased after the financial crisis, it remains higher than in the other Scandinavian countries. The development in aggregated borrowing may mask great differences across households and geographies. According to Danmark's Nationalbank, the housing burden in Copenhagen continues to increase, and lending has been growing faster than incomes since 2015.

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The credit analysis in our rated Danish programs considers our view of potential overvaluation of the housing market.

Interest only: reemergence of an old nemesis

Since their introduction in October 2003, interest-only mortgages have been used extensively by Danish households.

It took under five years for interest-only mortgages to comprise more than half of all Danish mortgage loans. This played a deciding role in house price increases before the financial crisis. The interest-only portion of Danish mortgages slightly increased during the COVID-19 pandemic, after its relative decline over the past decade.

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The proportion of interest-only loans in the main Danish capital centers has marginally increased in the wake of the COVID-19 outbreak (see chart 12).

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Since the previous financial crisis rules for interest-only loans have changed. The Danish FSA closely monitors and partly limits the use of interest-only loans. Despite increased scrutiny and better lending standards of the issuer, we continue to consider interest-only mortgage loans one of the main drivers of house prices in the Danish housing market

Initiatives to strengthen the housing market robustness

To reduce the vulnerability of the housing market, the Systemic Risk Council made recommendations to the government to increase the resilience of the most indebted homeowners, the robustness of the Danish economy and support financial stability. The recommendations included a limit on Danish homeowners' access to new interest-only loans for LTVs above 60%. It also discussed other measures including higher down payment requirements and amortization stipulations for highly indebted borrowers. The recommendations were supported by Danmarks Nationalbank, which estimates that amortization requirements will decrease house prices by 6% over 10 years. The government must respond but is not required to follow the recommendations. In its reply, the government found that the financial stability and robustness of Danish households against shocks to the economy are not currently threatened. Therefore, it believes there is currently no need for an intervention against the interest-only loans.

Tax change looming

In 2024, the Danish government will introduce a new valuation system that will serve as the basis for calculating property tax. Existing owners will not be charged more tax than they currently pay, but new owners will be pay taxes based on the updated valuations. Therefore, areas currently undervalued in the tax valuation will see an increase in charges going forward. This may make an onward sale of such properties more challenging and affect house prices for such locations. We expect most of the upward adjustments to tax valuations to occur around the major Danish cities, while rural areas may even get a discount. Given the implementation time, we expect homebuyers and sellers to adapt, but we will follow any effects on demand closely.

Mortgage Market Overview: The Economic Rebound Supports the Danish Housing Market

A strong budgetary position before the pandemic has enabled Denmark to contain the unprecedented economic shock, despite temporary deterioration in budgetary performance. External demand from key trading partners is set to rebound and support the export sector. The decline in COVID-19 infection rates and increasing vaccination rates result in further lifting of restrictions and resumption of consumption demand. The government's sizable fiscal policy support and the Next Generation EU plan, in our view, prevented longer-lasting damage to the economy. We expect the Danish economy to recover by 2.3% in 2021 and average 2.4% in 2022-2024, following the estimated economic contraction of 3.3% in 2020.

Unemployment increased to 5.6% in 2020 from 5% in 2019. We anticipate the rate will slightly rise to 5.8% in 2021, before a drop to 5.1% in 2024 in line with pre-pandemic levels. Still, according to our forecasts for 2021-2024, Denmark will have a lower unemployment rate compared to peer countries such as Belgium or France. In our view, the Danish labor market recovery will be supported by the COVID-19 stimulus package.

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Comparison Of Danish Covered Bond Programs

In 2021, the indexed weighted average LTV ratio in our rated programs has decreased thanks to substantial Danish house price growth. The credit coverage (foreclosure frequency and loss severity) has improved in most of our rated programs, mainly due to the lower LTV ratio and the application of revised guidance for criteria assessing residential loan pools. The improvement in foreclosure frequency is driven by the use of the new LTV curve, which considers effective loan to value (ELTV) ratios (based on 80% OLTV/20% CLTV). In the previous criteria, only the original LTV ratio was considered to calculate foreclosure frequency. The decrease in loss severity is mainly driven by the lower LTV ratio after adjusting for the house price index.

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

Charts 15 and 16 show that most Danish covered bond issuers are assigned high issuer credit ratings (ICRs). These allow most rated issuers' covered bonds to reach the 'AAA' rating based on jurisdictional support alone. The programs benefit from different numbers of unused notches by which the ICR can be lowered without affecting the covered bond program's ratings, all else being equal.

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Table 5

Chart 17 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 OC commensurate with the maximum collateral-based uplift.

Danish programs on average have lower credit and market risk compared to peer countries thanks to relatively low mortgage LTV ratios and the Danish matched funded covered bond feature. 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

In the context of strong Danish house price growth, we have carried out a scenario analysis with large drops in house prices to gauge whether these would affect the OC commensurate with our rating or the rating itself. In our current credit model, we consider that Danish house prices reflect an overvaluation of 7.3%. We have tested the effect of house-price drops of 20% and 30%, which is more severe than the 18% drop we observed in Denmark in the 2008-2012 crisis.

Table 6 shows the effect of the house price decline on our weighted-average loss severity calculation and the OC commensurate with the rating. The OC in line with the current rating does not increase significantly. These hypothetical house price drops do not affect the achievable rating on any of the programs either. Furthermore, in some programs the required credit enhancement for the rating is still floored by the largest obligor test (default of the 10 largest commercial borrowers).

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Related Transaction Updates

• Transaction Update: Nykredit Realkredit A/S (Capital Center C Mortgage Covered Bonds), Sept. 7, 2021
• Transaction Update: Realkredit Danmark A/S (Capital Center S Mortgage Covered Bond Program), Aug. 24, 2021
• Transaction Update: Jyske Realkredit A/S (Capital Center E Mortgage Covered Bonds), Aug. 4, 2021
• Transaction Update: Nykredit Realkredit A/S (Capital Center D Mortgage Covered Bonds), July 30, 2021
• Transaction Update: Nykredit Realkredit A/S Capital Center E (Mortgage Covered Bonds Program), July 30, 2021
• Transaction Update: Nykredit Realkredit A/S (Capital Center G Mortgage Covered Bonds), July 30, 2021
• Transaction Update: Nykredit Realkredit A/S (Capital Center H Mortgage Covered Bonds), July 30, 2021
• Transaction Update: Nykredit Realkredit A/S (Capital Center I Mortgage Covered Bonds), July 30, 2021
• Transaction Update: Realkredit Danmark A/S (Capital Center T Covered Bond Program), July 21, 2021
• Transaction Update: Nykredit Realkredit A/S General Capital Center Mortgage Covered Bonds, April 21, 2021
• Transaction Update: Danske Bank A/S (Cover Pool C Mortgage Covered Bonds), March 29, 2021
• Transaction Update: DLR Kredit A/S Capital Center B (Mortgage Covered Bonds), March 29, 2021
• Transaction Update: Nordea Kredit Realkredit A/S Capital Centre 1's Mortgage Covered Bonds, Feb. 5, 2021
• Transaction Update: Nordea Kredit Realkredit A/S (Capital Center 2 Mortgage Covered Bonds), Feb. 5, 2021
• Transaction Update: Totalkredit A/S Capital Center C Mortgage Covered Bond Program, Feb. 3, 2021
• 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

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

• European Economic Snapshots: A Faster-Than-Expected Restart, Sept. 29, 2021
• Credit Conditions Europe Q4 2021: Rampant Recovery, New Risks, Sept. 28, 2021
• Economic Outlook Europe Q4 2021: A Faster-Than-Expected Liftoff, Sept. 23, 2021
• Global Covered Bond Insights Q3 2021, Sept. 9, 2021
• Covered Bonds Outlook Midyear 2021: Credit Stable Despite Waning Support, July 23, 2021
• Covered Bond Harmonization In The EU Remains A Work in Progress, July 13, 2021
• Danish Covered Bonds: Proposal Outlines Harmonization Plan, Nov. 23, 2020
• Denmark 'AAA/A-1+' Ratings Affirmed; Outlook Remains Stable, Aug. 28, 2020
• Banking Industry Country Risk Assessment: Denmark, Aug. 27, 2020
• 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
• 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

Other research

• Housing Market Robustness Should Be Strengthened, Danmarks NationalBank, July 2, 2021
• 33rd Meeting Of The Systemic Risk Council, Systemic Risk Council, June 22, 2021
• Limitation Of Access To Interest-Only Loans For Highly Indebted Borrowers, Systemic Risk Council, June 22, 2021