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 issuer ratings and outlooks and a strong sovereign will continue to support ratings stability for Danish covered bonds despite increasing interest rates and continued inflationary pressure.

Overview: Denmark, A Small Giant

Denmark has the largest covered bond market in the world, with outstanding issuance totaling €454.7 billion (approximately 135% of GDP) at the end of 2021. Euro-denominated benchmark covered bond issuance remains niche, with only €0.5 billion issued so far in 2022 (see chart 1). Overall, we expect Danish euro-denominated benchmark covered bond issuance in 2023 to be higher than in 2022 but remain lower than 2019 issuance levels. This is due to continued relatively cheap Danish krone (DKK) funding. At the same time, issuance of DKK-denominated covered bonds will likely remain elevated due to refinance activity. However, the interest to refinance is likely to be lower, leading to lower issuance levels in 2023.

Chart 1

Chart 2

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. At the same time, foreign investor appetite for DKK-denominated covered bonds has increased. This is boosting market turnover and liquidity, but also lowering reliance on euro-denominated issuance (see chart 3).

Chart 3

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Implementation of the EU's Covered Bond Directive in 2021

Denmark completed the parliamentary process for transposition of the EU Covered Bond Directive into its covered bond legislation. The amendments to the affected law were published in more detail on March 16, 2022, and all secondary legislation has been finalized and is in effect from July 8, 2022. 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. Realkreditobligationer (RO; the previous covered bond designation) will be grandfathered unless issuance continues. In that case, the ROs must comply with updated valuation rules and OC requirements, and will be labeled as European covered bonds. Matched funded programs are exempt from the introduced liquidity requirements, while European-style saerligt daekkede obligation (SDO; the most common designation of issued Danish covered bonds) issuance must introduce new objective extension triggers for new issuance and outstanding covered bonds without extensions will be considered in the 180 days' liquidity calculation, which may increase liquidity requirements (see "European Covered Bonds Reach Harmonization Milestone As The Journey Continues," published on July 12, 2022).

Monetary policy tightens against high inflation

In line with global trends, inflation in Denmark increased to a 40-year high, reaching 10.1% in October 2022. Following the European Central Bank's (ECB) interest rate hikes in 2022, Danmarks Nationalbank raised its benchmark monetary policy rates in July and again in September 2022, up to the current 1.25% rate to curb soaring inflation. Market-based mortgage rates have increased even more. We expect that further rises in interest rates will put downward pressure on house prices in the coming years.

In September 2022, due to the current high inflation and a tight labor market, Danmarks Nationalbank recommended that the fiscal policy be tightened further to reduce the risk of a wage-price spiral with persistent high inflation.

Refinance auctions of particular interest

Approximately 50% of the Danish covered bond market comprises adjustable-rate mortgages financed by the continued issuance of 1-, 3-, or 5-year fixed-rate covered bonds. The interest-rate fixing takes place at adjustable-rate mortgage auctions on certain dates throughout the year with the results of the December auction taking effect in January 2023.

Historically, the average cost of adjustable-rate mortgages has been about 2%, but it has fluctuated over the years and has reached above 5% at times. Coming from historical low levels, the relative increase of this year's auctions combined with historical high CPI may add additional stress to Danish mortgage borrowers (chart 5).

Chart 5

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 came 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. Covered bond issuers may have several capital centers or registers.

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. 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 are agreed upon 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 an insolvency administrator under certain circumstances. Extensions will occur in 12 months intervals until new bonds can be sold. Further, certain bonds funding adjustable-rate mortgages have an extension trigger, which can be applied if the interest rate increase above 5% from the previous interest reset.

The amendments (effective from July 8, 2022) 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. Most 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 comprises 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 (the amount of overcollateralization that is commensurate with the maximum collateral-based uplift) for Danish matched funded covered bonds.

Further, the DFSA'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.

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").

Chart 8

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 less than five years after launching 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 great financial crisis. Following a slight decline due to limits on interest-only loans set by the Danish FSA the interest-only portion of Danish mortgages has increased again. Their popularity has been fueled by the COVID-19 pandemic, and the introduction of mortgage loan products with interest only for the full maturity of the loan. According to the FSA, higher house prices are increasingly attracting homeowners to loans with interest-only periods or variable rates.

Chart 9

The proportion of interest-only loans in the main Danish capital centers has marginally increased since the COVID-19 outbreak (see chart 10).

Chart 10

Since the previous financial crisis, the DFSA 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

Mortgage loans with long interest-only periods

At the end of September 2022, the Danish systemic risk council claimed that the growing share of floating-rate mortgages with deferred amortization is threatening the stability of the mortgage market. The statement followed earlier warnings from the Danish financial authority based on an investigative report published in the beginning of 2021.

The main concern from the DFSA is the contractual language in the loan documentation, which allows the lender to require further amortization should the current LTV increase above 75% for two consecutive years--i.e. if house prices were to decrease by 15%. In this case, borrowers may experience a payment shock. Therefore, the systemic risk council has emphasized the need for borrowers with these types of loans to have additional income buffers.

In our credit analysis, we typically apply an upward adjustment to our foreclosure frequency assumptions unless the loan is underwritten on a full repayment basis, or the borrower has sufficient time to separately build equity to proceed with the final repayment.

Since the FSA's initial report, which promised to surveil developments in the borrower segment, long-term interest-only loans have increased. The approximate percentage of the total lending from the largest Danish capital centers with interest only for life is displayed in table 3.

Table 2

According to the lenders, certain discretion is allowed as to the requirement for amortization, and the amortization requirement can be spread out over another 30-year amortizing mortgage, which may help mitigate payment shock risk for the borrower. Further, the reliance on the borrower to maintain the property may result in higher losses given default as the loan does not amortize.

Currently, we have not observed any performance differences of the interest-only for life mortgage loan product (as compared to other mortgage products), and we continue to assign our standard upward risk adjustments in our analysis of interest-only loans. We will continue to follow developments closely. We expect the interest-only for life product to increase expected (asset and liability) duration of the capital centers.

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 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 these properties more challenging and affect house prices in those 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.

Green covered bonds and ESG considerations

Growth in Danish green covered bonds has been limited. Nykredit Realkredit A/S helped pave the way for green covered bonds, while Realkredit Danmark A/S, Nordea Kredit Realkredit A/S, and recently Jyske Realkredit A/S 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. That said, the green covered bond market remains limited in size. 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 (see "ESG Credit Indicator Report Card: Covered Bonds," published on April 7, 2022).

In terms of governance, Danish issuers are not committed to maintain a minimum level of OC. Consequently, Available credit enhancement could potentially decrease 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.

Danish housing market slows down as interest rates and inflation rise

Following a significant uptick during the COVID-19 pandemic fueled by low interest rates and high demand, house price growth slowed down to 2.9% (year-on-year) in June 2022 from 11.0% (year-on-year) in September 2021. In recent months, mortgage activity has slowed due to rising interest rates, and there is evidence of lower house prices in some segments.

Chart 11

According to Danmarks Nationalbank, the interest rates on new mortgage loans disbursed in September 2022 (excluding administration fees) was on average 3%, which is 3.5 times higher than the interest rates on the loans disbursed the year before. The higher interest rate and inflation combined with slower economic growth prospects contributes to the slow-down in household demand for housing. After two years of historically high sales volumes, the number of housing transactions has fallen across the country for both single family houses and owner-occupied flats, and is more pronounced in and around the capital.

Chart 12

Rising interest rates, high inflation, and a weaker trading activity will likely put downward pressure on house prices, and we therefore expect price declines. On the other hand, the higher nominal wage increases, and the current rising construction costs will help to retain construction activity and support house price growth in the long term, in our opinion.

Despite a significant decreases after the financial crisis, Danish housing debt relative to disposable income remains higher than in other Scandinavian countries.

Chart 13

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

Mortgage Market Overview: Limited Effects From The Russia-Ukraine Conflict On The Danish Economy

The Danish economy has proven resilient to the adverse economic impact of the conflict in Ukraine because of its limited direct exposure. Weaker external demand from key trading partners will reduce exports, while surging inflation will erode household purchasing power and restrict consumption, and the monetary policy shift will likely weigh on investment activity. However, the Danish economy is coming from a strong position, characterized by high household wealth and pent-up demand, as well as a solid public finance position. We expect the GDP growth rate of 2.8% in 2022, following a strong recovery of 4.9% in 2021, and we forecast growth to average 1.5% in 2023-2025.

The labor market has benefited from the rapid economic recovery and supporting government measures. We estimate unemployment at 4.6% in 2022, the lowest level in more than a decade, before a slight increase to an average of 5.0% in 2023-2025. In our view, the labor market will benefit from the influx of Ukrainian refugees, and at a more structural level from gradual increases in the retirement age.

Table 3

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Comparison Of Danish Covered Bond Programs

Over 2022, the indexed weighted-average LTV ratio in our rated programs has decreased thanks to 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, although it was partially offset by the revision of our overvaluation assumptions of the Danish residential real estate market in January 2022.

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

Charts 16 and 17 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.

Chart 16

Chart 17

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 (see chart 18). Consequently, the available credit enhancement is also lower relative to peer countries.

Chart 18

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

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 16.8%. 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.

The OC in line with the current rating does not increase significantly in the most stressful scenario (see table 6). 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). The portion of loans with LTVs above the regulatory 80% limit would increase in such scenarios, and, if so, issuers would need to add additional collateral according to the law.

Table 4  |  View Expanded Table

Appendix

Table 5

Table 6

Table 7

Related Transaction Updates

• Transaction Update: Nykredit Realkredit A/S (Capital Center C Mortgage Covered Bonds), Oct. 14, 2022
• Transaction Update: Realkredit Danmark A/S (Capital Center S Mortgage Covered Bond Program), Oct. 14, 2022
• Transaction Update: Jyske Realkredit A/S (Capital Center E Mortgage Covered Bonds), Oct. 13, 2022
• Transaction Update: Nykredit Realkredit A/S (Capital Center D Mortgage Covered Bonds), Sept. 16, 2022
• Transaction Update: Nykredit Realkredit A/S (Capital Center I Mortgage Covered Bonds), Sept. 16, 2022
• Transaction Update: Nykredit Realkredit A/S Capital Center E (Mortgage Covered Bonds Program), Aug. 18, 2022
• Transaction Update: Nykredit Realkredit A/S General Capital Center Mortgage Covered Bonds, Aug. 18, 2022
• Transaction Update: Nykredit Realkredit A/S (Capital Center H Mortgage Covered Bonds), Aug. 18, 2022
• Transaction Update: Nykredit Realkredit A/S (Capital Center G Mortgage Covered Bonds), Aug. 17, 2022
• Transaction Update: Realkredit Danmark A/S (Capital Center T Covered Bond Program), June 23, 2022
• Transaction Update: Danske Bank A/S (Cover Pool C Mortgage Covered Bonds), Feb. 3, 2022
• Transaction Update: Nordea Kredit Realkredit A/S Capital Center 1's Mortgage Covered Bonds, Jan. 26, 2022
• Transaction Update: Nordea Kredit Realkredit A/S (Capital Center 2 Mortgage Covered Bonds), Jan. 26, 2022
• Transaction Update: Totalkredit A/S Capital Center C Mortgage Covered Bond Program, Jan. 4, 2022
• Transaction Update: Danske Bank A/S (Cover Pool D Mortgage Covered Bonds), Dec. 3, 2021
• Transaction Update: DLR Kredit A/S Capital Center B (Mortgage Covered Bonds), Nov. 29, 2021
• Transaction Update: Danske Bank A/S (Cover Pool I Mortgage Covered Bonds), Nov. 18, 2021

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 Credit Conditions Downside Scenario: Recession Risks Deepen, Oct. 12, 2022
• Sovereign Risk Indicators, Oct. 10, 2022
• Credit Conditions Europe Q4 2022: Hunkering Down For Winter, Sept. 27, 2022
• Economic Outlook Eurozone Q4 2022: Crunch Time, Sept. 26, 2022
• Global Covered Bond Insights Q3 2022, Sept. 8, 2022
• Denmark 'AAA/A-1+' Ratings Affirmed; Outlook Stable, Aug. 26, 2022
• Covered Bonds Outlook Midyear 2022: The Meaning Of Higher Interest Rates, July 18, 2022
• European Housing Markets: Soft Landing Ahead, July 13, 2022
• European Covered Bonds Reach Harmonization Milestone As The Journey Continues, July 12, 2022
• Banking Industry Country Risk Assessment: Denmark, June 9, 2022
• ESG Credit Indicator Report Card: Covered Bonds, April 7, 2022
• Asset Price Risks: Inflated Property Values Mean Higher Loss Assumptions In European RMBS And Covered Bonds, March 21, 2022
• 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