Stockholm (HedgeNordic) – The spreads between Scandinavian mortgage bonds and government bonds have been very low for many years due to central bank interventions and other market forces. The time of ultra-low interest rates and massive quantitative easing is over amid efforts to prevent inflation from spiraling out of control, triggering a significant spread widening in Swedish and Danish mortgage bonds.
The interest rate spread between mortgage and government bonds has widened significantly since the summer of 2021, currently reaching levels seen during the financial crisis. Mortgage bond rates in Denmark, for instance, have risen more than government yields, primarily reflecting higher risk premia stemming from higher volatility and uncertainty in mortgage rates. This higher volatility and uncertainty triggered a sell-off of Danish mortgage bonds across the board, creating a once-in-a-decade buying opportunity. Danish hedge fund boutique CABA Capital has launched a new “buy-and-hold” hedge fund with an operating life of three years that seeks to capitalize on the historically high spreads.
“Market participants are in the process of adapting to a new monetary policy reality and this provides new attractive investment opportunities.”
“Market participants are in the process of adapting to a new monetary policy reality and this provides new attractive investment opportunities,” says Mette Østerbye Vejen (pictured right), CEO of CABA Capital. “That is why we are launching the new fund now,” she explains. “There is a window of opportunity right now, but we know from experience that this window will close again,” confirms Carsten Bach (pictured left), co-founder and CIO at CABA Capital.
“Pension funds have sold off their mortgage bonds, presumably to provide liquidity for collateral when hedging risks in financial contracts,” explains Bach. Japanese investors, who have traditionally been among the largest buyers of Danish mortgage bonds, have been net sellers of these bonds, according to Bach. “Investor interestin Danish mortgage bonds with long maturities has decreased from Japanese investors in particular, and they have for a long period been net sellers of these bonds.” Rising prices on the Danish housing market in recent years have also contributed to creating imbalances in the Danish mortgage bond market.
The Flex
With the Danish mortgage bond market’s challenges echoing those of neighboring Sweden, the newly launched hedge fund, CABA Flex, predominantly invests in non-callable Danish five-year bullet-covered bonds and Swedish bullet Bostäder bonds with no optionality. The acquired bonds must have a remaining term of less than five years at the time of investment, with the entire bond portfolio expected to be held for three years before being liquidated. “This is a buy-and-hold fund that is liquidated after three years,” says Mette Østerbye Vejen. “We liquidate both the portfolio and the fund after three years. This means that we offer investors a unique vehicle to tap into a very specific and unique investment opportunity.”
“With the current spread levels, we are looking to lock in the spread so that the strategy yields 40-50 percent in returns, gross of fees.”
“With the current spread levels, we are looking to lock in the spread so that the strategy yields 40-50 percent in returns, gross of fees,” argues Bach. If the same strategy had been employed at any point in the past 20 years and held for three years, the worst possible return outcome would have been four percent. “Amazingly we would have no negative returns. Depending on which day you locked in the portfolio, the strategy would have yielded between four and 78 percent.”
The interest rate risk is hedged with swaps or government bonds in local currency, which minimizes the exchange rate risk, according to Bach. “All that remains is the credit spread between the mortgage and government bonds and this spread is leveraged to create an attractive return,” he explains. The biggest risk associated with this investment is the possibility of significant spread widening after the initial investment. “This will cause a price loss on the bonds before the strategy has made any money,” says Bach. “The risk in CABA Flex is greatest at the start of the investment period, but with every day that passes, the remaining maturity of the bonds becomes shorter, and the price risk thus becomes smaller as time goes on.”
