bonds & bold: cheap, cheaper, covered bullets

12 November 2021

Bonds & bold: Cheap,cheaper, covered bullets

Marketing communication

This report has not been prepared in accordance with legal requirements designed to promote theindependence of investment research, and is not subject to any prohibition on dealing ahead of thedissemination of investment research. Nordea Markets may have positions in the mentioned financialinstruments.

Anders Skytte Aalund | Simone Rebbe

Danish covered bullet bonds for DKK 42bn are up for auction later this month.The value is attractive when comparing to the alternatives so get ready to buy!

In this edition of Bonds & bold, I look at the upcoming refinancing auction of the covered bullet bondsexpiring on 1 January. My overall take on the auction is that right now there isn’t anything that oers a betterpick-up than the bonds up for auction.

You might argue that callable bonds are better due to their very poor performance this year and highspread levels, but the significant uncertainty as to whether inflation is transitory is likely to make marketsvolatile going forward. So for me, it’s two very dierent investments when it comes to risk, and therefore thecomparison is not straight forward.

Some people are concerned about potential issuance pressure on covered bullet bonds as the funding curvesteepens, but historical data do not support this concern. What they do show is that the issuance will continueto be in callable bonds but with a supplement of floater bonds. The auction in February potentially have many5-year bonds up for auction, but given the decreasing refinancing percentages over the last many auctionsand the reduction in the bullet segment in general, I can’t see why investors should be scared by this alreadynow.

All in all, I find that the fundamental value of the bonds is fine and I don’t foresee pressure on spreadsaround the auction.

The auctions start 17 November . Please reach out to your daily Nordea contact for a detailed sheet with allinformation on all the 46 auctions.

Marketing communication: This report has not been prepared in accordance with legal requirements designed to promotethe independence of investment research, and is not subject to any prohibition on dealing ahead of the dissemination ofinvestment research. Nordea Markets may have positions in the mentioned financial instruments.

corporate.nordea.com/article/69622/bonds-bold-cheap-cheaper-covered-bullets

https://corporate.nordea.com/article/69622/bonds-bold-cheap-cheaper-covered-bullets

Covered bullets the cheapest bonds available

The amounts up for auction, DKK 41.9bn plus a 3-year floater (DKK 14.5bn), should not scare anyone away.Especially since the value is as attractive as it is, which I will show below.




The two tables below show that no matter what market you compare it to or what relative value metric youuse there is nothing that matches Danish covered bullets (with a few exceptions where the FX hedge is notcompletly matched).

The tables might be hard to read, but you can either download the tables as a picture and open them or youcan find the tables and much more in the covered bullet quant pack in the attachment below (page 16).

The main reason for the high value is the squeeze in EUR bonds which is best illustrated by the widening ofthe bond-swap spread in recent months. This widening is clearly very supportive for covered bullets relativeto DGBs.




The widening of the bond-swap spread has left the spread between 3-year covered bullets and 3-yearDanish government bonds at 40.8bp, which is a record high over the past many years if we disregard theMarch 2020 meltdown.




Another way to illustrate the value of covered bullets is that the zero return threshold on carry/roll on coveredbullets is 2 years as opposed to 5 years in a Danish government bond.

An example of the value can be seen in the chart below where I have compared the 5-year point to theFrench covered bond issuer CFF.




Finally note that EUR/DKK is getting closer to intervention levels which, all else equal, will be supportive forthe short end the Danish curve if intervention materialise.

Relative to callable bonds covered bullets look fine

Some investors might be tempted to buy callable bonds since the spread has widened significantly this yearas opposed to the spread of covered bullets.




Note that the recent dynamic in volatility and the shape of the curve continue to mitigate each other so thatthe OAS is kept relatively stable and the BPV continues down. Read more about this dynamic in Bonds & bold:Callable bonds being pulled in dierent directions and Bonds & bold add-on – the eect on duration. Thismeans that even though the bonds continue to underperform, they don’t get cheaper on the OASSWAP



https://corporate.nordea.com/article/68882/bonds-bold-callable-bonds-being-pulled-in-different-directions


https://corporate.nordea.com/article/68922/bonds-bold-add-on-the-effect-on-duration


But unfortunately, it’s not as simple as just lookink at spread to swap. Looking at the convexity-adjustedhorizon return on callable bonds versus the carry/roll on covered bullets, the excess pick-up is not large. Inmy view, the expected pick-up should be larger to compensate for the risk. Remember that Sharpe ratios overthe past many years dictate buying of bullets: Bonds & bold: Covered bullets the best investment in Denmark.Both historically and going forward.



https://corporate.nordea.com/article/65842/bonds-bold-covered-bullets-the-best-investment-in-denmark-both-historically-and-going-forward



Comparing using the spread to Danish government bonds we clearly see that the picture is more balancedthan the spread to swap number indicated and this is constistent with the limited excess return in callablebonds relative to covered bullets.




The current funding curve will not result in a significant growth in thecovered bullets

Looking at the historical correlation between the extra cost of funding in callable bonds versus bullets (5YFlex) and the net issuance, I find that there is no reason to believe that there will be a sharp increase in theissuance of covered bullets. Not even if the 2%53 bond opens and the extra cost of funding jumps.




The number shows that when the funding curve gets too steep, borrowers prefer funding themselves incallable bonds and floaters but not bullets. In other words, bullets seem to be too much in the middle of theroad, i.e. if you are concerned about rates going up, you prefer callable bond funding, and if you are lookingfor the cheapest funding right now, you prefer floater funding.

Homeowners have started to feel the eect of inflation on their energy costs, so I believe that this, combinedwith the increasing talk about inflation, could tilt them towards callable bonds rather than short funding.




The refinancing auctions next year a concern?

Looking ahead into 2022, the first refinancing auction in February of the April 2022 bonds will potentiallyhave many 5-year bonds. Given the low refinancing percentages in the longer maturities that last manyauctions, I would not be too concerned about this, and I believe that the current pick-up reflects this potentiallarge issuance.

Previous editions:

The one you don’t like to read but need to read! here

The one about how volatility and curve shape pull callable bonds in dierent directions here

The one about why Swedish investors are throwing away billions of SEK here

The one about why it’s No Time To Die in the callable market here

The one about lycra versus the market price of risk here

The one about how the trading pattern in callable bonds has changed and how to exploit it: here

The one about how the covered bullet auctions are a non-event and a historical approach to assessingwhether callable bonds will perform: here

The one about how the Danish central bank has lost the upper hand: here



https://corporate.nordea.com/article/69166/bonds-bold-the-one-you-dont-like-to-read-but-need-to-read


https://corporate.nordea.com/article/68423/bonds-bold-throwing-away-billions-of-sek

https://corporate.nordea.com/article/67851/bonds-bold-no-time-to-die

https://corporate.nordea.com/article/67670/bonds-bold-lycra-versus-the-price-of-negative-convexity

https://corporate.nordea.com/article/67373/bonds-bold-exploit-changed-trading-patterns-in-callable-bonds-decrease-in-net-position-ultimately-good-news-for-dgbs

https://corporate.nordea.com/article/67186/bonds-bold-refinancing-auctions-much-ado-about-nothing

https://corporate.nordea.com/article/67088/bonds-bold-dgbs-are-aaa-but-who-cares


The one about how the Fed changed the global playing field: here

The one about how to position for tapering: here

The one about why the supply of callables will continue: here

The one about why callables are attractive and we are in a chicken race: here

The one about why bullets are better than callables. Historically and going forward: here

The one about the rescue boat getting closer (buybacks): here

The one about why AIT is bad for callable bonds: here

The one about why Nykredit bonds outperform RD bonds: here

The one about why grey DGBs will perform when the Danish central bank introduces green bonds and thecurse of negative convexity: here

The one about playing the borrower buyback smart and DGBs in light of negative vaccine news: here

The one about why borrower buyback will bail out investors: here

The one about hedging drawdowns using swaption overlays: here

The one about hedging smart and finding empirical durations using Machine Learning: here

The one about central banks making Danish yields higher: here

Anders Skytte [email protected]

Simone [email protected]



https://corporate.nordea.com/article/66982/bonds-bold-the-fed-has-changed-the-global-playing-field-over-the-summer

https://corporate.nordea.com/article/66226/bonds-bold-here-is-how-to-position-yourself-for-tapering

https://corporate.nordea.com/article/66071/bonds-bold-supply-of-callable-bonds-will-continue-but-can-flattening-of-us-curve-mitigate-that

https://corporate.nordea.com/article/65930/bonds-bold-the-danish-market-is-now-a-chicken-race


https://corporate.nordea.com/article/65662/bonds-bold-implosion-in-the-danish-callable-bond-market-but-the-rescue-boat-is-getting-closer

https://corporate.nordea.com/article/65468/bonds-bold-introduction-of-an-average-inflation-target-regime-in-eur-will-hit-danish-callable-bonds

https://corporate.nordea.com/article/65419/bonds-bold-want-to-beat-the-market-buy-nykredit-and-sell-rd

https://corporate.nordea.com/article/65154/bonds-bold-why-grey-dgbs-will-perform-when-green-dgbs-are-launched

https://corporate.nordea.com/article/64975/bonds-bold-can-buybacks-be-played-smart-and-why-we-are-positive-on-dgbs-despite-bad-vaccine-news

https://corporate.nordea.com/article/64795/bonds-bold-borrowers-will-bail-out-bond-investors-but-not-yet

https://corporate.nordea.com/article/64455/bonds-bold-large-drawdowns-get-more-frequent-in-the-callable-bond-market-what-to-do

https://corporate.nordea.com/article/64295/bonds-bold-danish-callable-bonds-should-do-well-the-coming-weeks-but-make-the-hedging-smart

https://corporate.nordea.com/article/64094/bonds-bold-no-sign-of-spread-compression-in-longer-dated-bonds-despite-the-de-facto-rate-cut


https://www.nordea.com/

https://www.nordea.com/

bonds & bold: cheap, cheaper, covered bullets

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