Like the United States, Europe is a land of deep, broad liquidity pools, but it also a land of niche markets, such as Danish callable mortgage bonds, which have become hugely popular among traders both inside and outside of Denmark throughout the past decade.
Add to that the surging demand for managed investment products of all stripes in Denmark (see “That’s a lot of shoes,” belwo), and you can see why money managers like Michael Rothman have chosen to inhabit the niche. His company has generated a smooth 12% to 15% annually trading in the secondary market, using mainly cash and forward contracts/repos in bonds maturing in the next one to five years.
The Copenhagen Stock Exchange does not list bond futures, but Danish banks do administer an OTC trading platform that can be accessed by high net-worth individuals via member banks. Rothman, however, warns of low liquidity. “If you want to cover a position using futures, you are best using the German Schatz or Bund,” he says, adding that an active spread market has developed between Danish mortgage bonds and Bund futures.
Since 1986, Rothman's niche within the niche has been finding opportunities in less-actively traded series, so-called “off-the-run” bonds. Rothman says Danish pension funds and institutional investors are not active in the sector. “This lack of market participation and the illiquidity it creates, coupled with the inherent valuation complexity resulting from the redemption profile of mortgage bonds (the call feature found in mortgage bonds), has led to an inefficient market in this niche sector and a consequent yield arbitrage opportunity.”
The strategy relies on long-standing relationships with institutional participants, to maintain its unique market-making position. “Our ability to provide market liquidity in an otherwise illiquid market enables us to earn higher spreads than might normally be expected,” he explains. “It has been a good business for years but suddenly, over the past few years, we are getting a lot of money from abroad, although not much yet from the United States.”
The market has a fascinating history and predates the securitization of U.S. mortgages by 180 years, having been launched by a consortium of issuers in 1796 to dilute the risk of default on masses of mortgages issued after a fire destroyed one quarter of Denmark one year earlier. The bonds have been a cornerstone of the nation's real estate apparatus since, but foreigners didn't take to them in large numbers until after the Danish government implemented a fixed exchange and interest rate policy with the euro. “This is the seventh-largest mortgage bond market worldwide,” explains Rothman. “That's not just because it has been around so long, but also because Danes can mortgage up to 80% of the value of their homes. Plus, we've never had a failure, and they're rated AAA.”
The market began taking its current form in the 1950s, when old mutual credit associations gave way to independent mortgage banks that offered easy credit. In 1970, the government simplified loan structures and gave the Minister of Housing authority to deny licenses for new institutions. The result was a gradual drop in the number of lenders from 24 to seven as existing entities merged and new ones stopped popping up. The market benefited with fewer, but deeper and more liquid bond series.
The Danish bond market continued its simplification and in the 1980s, they started allowing loans based on a property's cash value and raised the loan-to-value rate to its current 80% of a property's total value.
Whether or not the growth in participants will cause Rothman to lose the inefficiencies that he has been able to exploit is yet to be seen.