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Institutions close European mortgage gap

Investors move into market in pursuit of better yields

Mark Willems sees PGGM looking at the mortgage market as a way to get a better return than from lower-yielding fixed income.

Opportunities in European mortgages are emerging, with pension funds beginning to fill the funding gap left by European banks in the aftermath of the global financial crisis, estimated by McKinsey & Co. to reach €3.4 trillion ($4 trillion) by 2019.

Now that banks have tightened up on issuing residential mortgages as a result of capital requirements imposed by Basel III regulation, the market has opened to new players, including money managers.

And investors are finding a variety of ways to access this market, largely through direct funding of non-bank mortgage companies and investing in covered bonds. Some new vehicles are arriving on the radar of institutional investors, who have been eager to find new fixed-income investments after quantitative easing pinched bond yields.

Such strategies have allowed asset owners in the Netherlands, in particular, to invest directly in residential mortgages in the past few years through pooled funds provided by investment management companies such as Dutch Mortgage Funding Co. More recently, in November, Stabelo AB, Stockholm launched a similar vehicle to lure Swedish institutional investors.

Taking note of booming residential markets in Europe as well as these new ​ players, asset owners are taking mortgage-type strategies more seriously, sources said. In addition, money managers report increased investor appetite for mortgage-backed derivative investments, such as the covered bonds that banks use to fund their mortgage programs.

Asset owners could realize an annualized return of around 2.7% investing in mortgage loans pooled by companies such as Dutch Mortgage, according to Marieke Hut, director at Dutch Mortgage Funding in Amsterdam. That compares with the annualized 1.02% return on covered bonds that investors could earn in the past three years, according to the Markit Iboxx covered bond benchmark. Yield offered by these covered bonds stood at 0.47%, while similarly rated 5-year Dutch government bonds had negative yield of 0.14%.

Attractive qualities

One institution that finds mortgages attractive is PGGM, manager of the €188.5 billion ($226 billion) Pensioenfonds Zorg en Welzijn, Zeist, Netherlands. "Investing in Dutch mortgages offer (an) attractive illiquidity premium combined with low risk and diversification benefits," said Mark Willems, PGGM's senior strategist within institutional business. "For us, mortgages are an alternative to low-yielding fixed-income assets, mainly investment-grade credits."

PGGM allocated €2 billion into these strategies in the past two years with Dutch Mortgage Funding. The mortgages PGGM invests in are provided to employees in the health-care sector only, Mr. Willems said. PFZW's 2.6 million participants work in health care.

Asset owners also found that by investing directly in residential mortgage lending they could earn more than through other kinds of residential mortgage investments.

Hampus Broden, founding partner of Stabelo in Stockholm, said the main benefit of direct mortgage investments is the very significant yield pickup relative to, for example, covered bonds. Ms.Hut added that investors can earn 170 basis points over the coupon of Dutch government bonds.

In the Netherlands, Dutch Mortgage Lending has secured about €12 billion in commitments from 15 domestic pension funds since the firm launched in 2014. Ms. Hut said that since inception, the company has deployed €10 billion of that into Dutch mortgages.

Gearing up in Sweden

In Sweden, Stabelo is gearing up to cater to domestic institutional demand in a similar way. Investors will commit to a pooled investment vehicle that distributes mortgage loans to consumers through online lender Avanza.

Stabelo's pooled vehicle is not limited to a specific investor. "We have secured commitments from insurance companies, occupational pension plans and public Swedish pension funds," Mr. Broden said. He declined to name the investors.

Stabelo's business, like Dutch Mortgage Funding, is aimed at defined benefit funds, which may want to use investments in mortgage strategies for asset-liability matching in their portfolios.

European regulators have recognized both Dutch Mortgage Funding and Stabelo as alternative money managers under the Alternative Investment Fund Managers Directive.

Mortgage-driven strategies succeeded in some European countries even before the global financial crisis in the form of covered bonds. Sources said interest for them in Europe has been rising in the past three years as this $2 trillion market did not develop in other parts of the world to the same extent.

Dag Messelt, head of Nordic investment specialists and international business development at Alfred Berg, a subsidiary of BNP Paribas Asset Management, in Oslo, said a big advantage of the Nordic covered bonds market is that it's not being distorted by the European Central Bank's QE program, which only takes in euro-denominated bonds.

The low default level and the AAA rating adds to the attractiveness of covered bonds for both domestic and global investors.

Japan investors interested

The Danish mortgage market, in particular, attracts institutional investors from Japan, who also want to diversify from domestic Japanese fixed-income with returns influenced by Bank of Japan's monetary policy.

Steve Williams, senior portfolio manager at Nikko Asset Management in London, said: "(Our) Japanese investors get a relative yield pickup by diversifying away from domestic assets, where (Japanese government bonds) currently yield some 0.08%. By comparison Danish mortgages can offer yield in (yen) terms close to 2%." Nikko's Danish covered bond strategy grew to $2.3 billion since inception in 2016, Mr. Williams said.

Local asset owner, ATP, Hilleroed, Denmark, also utilized mortgage bonds for low risk exposure in its diversified portfolio, a spokeswoman at the 758.1 billion Danish kroner ($122 billion) pension fund said. However, she declined to provide additional details of ATP's strategy.

In the U.K., mortgage strategies also have seen demand from investors. Insight Investment Management runs a 1.5 billion ($2 billion) pooled secured finance fund that's becoming popular with U.K. pension funds.

"Our clients in the pooled fund invest various amounts, from tens to hundreds of millions but we also have some segregated mandates from larger clients, which generally start at 150 million" said Jeremy Deacon, senior portfolio manager at the firm in London. Mr. Deacon would not name any clients that have committed to Insight's strategy.