Conversions of 30-year Mortgage-Credit Bonds During the Last 10 Years

During the past 10 years borrowers have to a large extent replaced high-yield mortgage-credit loans with loans at lower coupon rates. The growing popularity of adjustable-rate loans^[1] from the end of the 1990s also brought a shift from traditional callable mortgage-credit loans to adjustable-rate loans.

The proportion of high-yield mortgage-credit bonds (in this article comprising mortgage-credit bonds with coupons of 9, 10, 11 and 12 per cent) has been falling since 1994. While they constituted 63 per cent of the total circulating volume of mortgage-credit bonds in the mid-1990s, they now make up only 1 per cent, cf. Chart 2.

Traditional mortgage financing has been based on callable mortgage-credit bonds. During the past 10 years such bonds have typically had a coupon of 6 or 7 per cent. In the period from 1994 to 1998, mortgage-credit bonds with a coupon of 6 per cent made up 30-35 per cent of the total circulating volume of mortgage-credit bonds. As the supply expanded in the late 1990s, the proportion of 6-per-cent-coupons increased to more than 50 per cent. In the last few years the share has been 35-40 per cent. In April 2003, the circulating volume of 6-per-cent coupons was kr. 420 billion. The percentage of mortgage-credit bonds with a coupon of 7 per cent has fluctuated more, and is currently around 5 per cent of the total circulating volume of mortgage-credit bonds. Adjustable-rate loans, which were introduced in the mid-1990s^[2], have mainly been financed via issues of uncallable bonds with a coupon of 4 per cent, and to a lesser degree 5 per cent.

Development in the 30-year mortgage-credit bonds with a coupon of 7 per cent

The latest 30-year mortgage-credit bonds with a coupon of 7 per cent comprise three series^[3] maturing in respectively 2032, 2029 and 2026. In April 2003 the circulating volume in the three series was kr. 55 billion, cf. Chart 3.

Development in the circulating volume of 30-year mortgage-credit bonds with a coupon of 7 per cent	Chart 3
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in 7-32s, 7-29s and 7-26 (all with four annual due payment dates), stated at nominal value. The extraordinary redemptions and the total are the sums of the values for the 7-32, 7-29 and 7-26. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion.
Source: Nordea Analytics and own calculations.

The 30-year mortgage-credit bond with a coupon of 7 per cent maturing in 2029 (the 7-29) was opened in the autumn of 1996 and closed again three years later. Even in the opening period of the 7-29 it was for a long time not possible to make new loan offers because the price exceeded par^[4]. There have been several extraordinary redemptions in the series of between 10 and 20 per cent, so that the current circulating volume has been reduced to just over 14 per cent of the peak volume in circulation. This development is shown via the "pool factor"^[5], cf. Chart 4. In April 2003 the circulating volume was kr. 17 billion, compared to the peak circulating volume of kr. 127 billion in mid-1998, i.e. less than 5 years earlier. For the other two 30-year mortgage-credit bonds with a coupon of 7 per cent, the 7-32 and the 7-26, the same trend can be seen. In the periods when the prices have exceeded par, extraordinary redemptions have been made, so that the circulating volumes have been reduced significantly. In April 2003 the pool factors for the 7-32 and the 7-26 were respectively 25 and 17 per cent, cf. Appendix 1.

Development in the 7-29	Chart 4
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in the 7-29 (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The calculation of the extraordinary redemptions is based on the current circulating volume. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes.
Source: Nordea Analytics and own calculations.

Development in the 30-year mortgage-credit bonds with a coupon of 6 per cent

The latest series of 30-year mortgage-credit bonds with a coupon of 6 per cent mature in respectively 2035, 2032, 2029 and 2026. In April 2003 the circulating volume in the four series was kr. 323 billion, cf. Chart 5. In the new series maturing in 2035 (the 6-35), which replaced the 6-32 in September 2002, loan offers can no longer be made since the price exceeded par in December 2002. The total circulation in this series is kr. 28 billion.

Development in the circulating volume of 30-year mortgage-credit bonds with a coupon of 6 per cent	Chart 5
Note: The Chart shows all 6-32s, 6-29s and 6-26s from all mortgage-credit institutes (all with four annual due payment dates), stated at nominal value. The extraordinary redemptions and the total are the sums of the values for the 6-35, 6-32, 6-29 and 6-26. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion.
Source: Nordea Analytics and own calculations.

The circulating volume of the 30-year mortgage-credit bond with a coupon of 6 per cent has also declined significantly within a short span of years. Unlike the 7 per cent bonds, the 6-per-cent coupons were, however, (generally) priced below par up to mid-2002. The decline in the circulating volume of mortgage-credit bonds is therefore not a result of extraordinary redemptions, but mainly of bond purchases in the market.

For the 30-year mortgage-credit bond with a coupon of 6 per cent maturing in 2026 (the 6-26), the primary bond issued in connection with the major conversion wave in 1993-94, the circulating volume has been reduced to 29 per cent from when the circulating volume peaked. This decline is only to a very limited degree related to extraordinary redemptions, cf. Chart 6. On the contrary, the majority by far of the bonds have been bought up in the market at prices below par. In April 2003 the circulating volume was kr. 52 billion, compared to the maximum circulating volume of kr. 182 billion in mid-1994. Provided that all 6-26s had been issued by early 1996, the expected pool factor in 2003 would have been 87 per cent if the only reductions had been the ordinary redemptions. The pool factor would not have been reduced to 29 per cent until around 2019. For the two other 30-year mortgage-credit bonds with a coupon of 6 per cent a similar trend is seen. In April 2003 the pool factors for the 6-32 and the 6-29 respectively were thus 87 per cent and 48 per cent, cf. Appendix 1.

Development in the 6-26	Chart 6
Note: The Chart shows the 6-26s from all mortgage-credit institutes (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The outstanding volume of 6-26s peaked in as early as mid-1994 at kr. 182 billion. This is not reflected in the Chart, however, since there are only daily observations from end-1995 onwards. The calculation of the extraordinary redemptions is based on the current volume in circulation. Total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes. The calculated pool factor is based on an annuity bond.
Source: Nordea Analytics and own calculations.

Conversion waves and financing alternatives

The reduction in the 30-year 7-per-cent coupons has taken place in two stages. The first extraordinary redemptions of the 7-29s and 7-26s began inmid-1998 and lasted until 1999. In this period the two series were reduced by a total of kr. 70 billion, cf. Chart 3. Although it is difficult to say for certain which alternative financing options the borrowers chose, the same period saw a growing influx of 30-year 5-per-cent coupons, which could indicate that in that period many borrowers opted for downward conversion with an unchanged or slightly longer maturity, cf. Chart 2.Reference is made to Box 1 for a more detailed review of mortgage-credit financing concepts. The next period of large extraordinary redemptions of 30-year 7-per-cent coupons started up to the January quarter of 2001. Extraordinary redemptions since 2001 have totalled kr. 150 billion, and it is estimated that a large proportion of the borrowers have opted for refinancing via adjustable-rate loans, cf. Chart 7. Adjustable-rate loans as a proportion of the circulating volume of mortgage-credit bonds have thus increased from 2 per cent in early 1999 to 27 per cent in March 2003.

Redemption and conversion of mortgage-credit loans – various concepts	Box 1
If the borrower wishes to redeem a mortgage-credit loan (prematurely) at the mortgage-credit institute, this can in principle be done in two ways: as a bond redemption or as a cash redemption1. Bond redemption: Irrespective of loan type, the borrower may at any time hand in bonds of the same type (securities code) as that on which the mortgage-credit loan is based, and thus redeem the loan. This is done via purchases in the market. Cash redemption: For callable mortgage-credit loans the outstanding bond debt may at any time be redeemed at par value. Conversions: A redemption of a mortgage-credit loan financed via a new loan from a mortgage-credit institute is known as a conversion. If the general level of interest rates is falling, it may be advantageous for the borrower to convert downwards, i.e. the old loan based on bonds with a higher coupon is redeemed at par, and a new loan is raised with a lower yield and thereby lower payments. Upward conversions are seen when interest rates are increasing, i.e. the existing loan is redeemed and replaced by a new loan based on bonds with a higher coupon. The effect of an upward conversion is a lower outstanding debt on the loan since the new loan can be issued at a higher price (due to the higher coupon) than that at which the old loan is redeemed. Payments on the new loan are typically higher than on the old one. An upward conversion enables the borrower subsequently to convert downwards if interest rates later decline. Upward conversion always takes place via redemption of bonds. A sideways conversion means that a callable mortgage-credit loan is replaced by an uncallable loan, i.e. an adjustable-rate loan – or vice versa. The yield on an adjustable-rate loan is based on the level of interest rates at the short end of the yield curve. The borrower may gain an immediate advantage from opting for an adjustable-rate loan, particularly if short-term interest rates are lower than long-term interest rates, but the risk profile of the loan also changes.
1     In the statistics borrowers' redemptions of mortgage-credit loans are always stated as "early redemptions" on the loan side and as "other redemptions" or "redemption by extraordinary drawings" on the bond side.

Circulating volume of mortgage-credit bonds broken down by selected bond series and types of lending	Chart 7
Note: Adjustable-rate loans, other mortgage-credit bonds and the 30-year series are stated at nominal value on a monthly basis. 30-year 7-per-cent coupons: 7-32, 7-29 and 7-26; 30-year 6-per-cent coupons: 6-35, 6-32, 6-29 and 6-26. Data for adjustable-rate loans is available from January 1999 onwards. The December figures for 1999-2002 are affected by the auctions of the bonds on which the adjustable-rate loans are based.
Source: Nordea Analytics, Danmarks Nationalbank and own calculations.

During the past 10 years the price of 30-year 6-per-cent coupons has been generally below par until mid-2002, so the reduction in these series has mainly been via bond purchases. There is no clear picture of the financing alternatives for these borrowers up to the late 1990s when adjustable-rate loans began to win ground. It should, however, be noted that for a brief period of a few months in mid-2000 there was an increased influx of 30-year 8-per-cent coupons totalling kr. 26 billion. This could indicate that some borrowers opted for upward conversions in this period. Property trading in general may also affect the reduction in the 30-year mortgage-credit bonds with coupons of 6 and 7 per cent, since new home purchases may be financed differently than the previous owner's terms.

The call option which is an integral part of the 30-year mortgage-credit bonds means that the adjusted duration is more sensitive to the development in interest rates than is the case for uncallable bonds^[6]. Without adjustment for the call option, a 30-year mortgage-credit bond would have a duration of 8-10 years. If the call option is included in the calculation, however, the development in interest rates will influence the duration. For example, a drop in interest rates may make it attractive for borrowers to convert downwards, thereby reducing the duration.

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[1] For a detailed review of adjustable-rate loans, reference is made to Anders Møller Christensen and Kristian Kjeldsen, Adjustable-Rate Mortgages, Danmarks Nationalbank, Monetary Review, 2nd Quarter 2002.

[2] Adjustable-rate loans were previously used in the Danish mortgage-credit market in 1976-85, cf. Peter Engberg Jensen, Realkreditlån med rentetilpasning – en større succes denne gang (Mortgage-credit loans with interest-rate adjustment – a greater success this time (in Danish only)), Finans/Invest, December 1997.

[3] In this article a series comprises all the securities codes (i.e. different issues), with the same coupon, maturity and number of due payment dates. The 7-29 series thus comprises 8 different securities codes, all of which have a coupon of 7 per cent, mature in 2029 and have 4 annual due payment dates. The term "latest" indicates that all of the series shown were opened in the 1990s.

[4] Mortgage-credit institutes have entered into a gentleman's agreement not to make loan offers entailing issue of callable mortgage-credit bonds at a price exceeding par. Loan offers which have already been made and which may be binding for up to 6 months are, however, excepted.

[5] The pool factor shows the current circulating volume of mortgage-credit bonds in a series as a ratio of the maximum outstanding volume in the series. The pool factors shown have not been adjusted for known extraordinary redemptions. These will not affect the pool factor until the due payment date. In connection with investment considerations, or when using risk models, it will, however, be relevant to include the extraordinary redemptions as soon as they are known.

[6] For a detailed review of the duration concept, reference is made to Peter Jayaswal, Danmarks Nationalbank's Portfolio of Domestic Bonds, this Monetary Review, page 45.

Appendix 1: development in 30-year mortgage-credit bonds with coupons of 6 and 7 per cent

Development in the 7-32	Chart B1
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in the 7-32 (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The calculation of the extraordinary redemptions is based on the current circulating volume. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes.
Source: Nordea Analytics and own calculations.

Development in the 7-26	Chart B2
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in the 7-26 (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The calculation of the extraordinary redemptions is based on the current circulating volume. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes.
Source: Nordea Analytics and own calculations.

Development in the 6-32	Chart B3
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in the 6-32 (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The calculation of the extraordinary redemptions is based on the current circulating volume. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes.
Source: Nordea Analytics and own calculations.

Development in the 6-29	Chart B4
Note: The Chart is based on daily observations from all mortgage-credit institutes with issues in the 6-29 (all with four annual due payment dates). The calculations of the pool factor and the extraordinary redemptions are based on nominal values. The calculation of the extraordinary redemptions is based on the current circulating volume. The total extraordinary redemptions for the individual due payment dates are only shown if they exceed kr. 2 billion. The price is a weighted average of the prices of the individual securities codes.
Source: Nordea Analytics and own calculations.