Rising Rates Could Leave Mortgage Trusts Stranded

Sydney Morning Herald

Friday June 10, 1994

Jocelyn Eastway

LEADING research and advisory firm IPAC has put several of its mortgage trust recommendations "on hold" due to concerns about the trusts' high exposure to fixed-rate loans.

In a draft circular on mortgage funds, released this week to its research clients, IPAC says mortgage trusts with a high component of fixed-rate loans carry much more risk in the current climate of rising interest rates.

IPAC is concerned that some of these trusts are now "locked in" to relatively low fixed-interest rates for the term of these mortgages. The funds could be left behind when interest rates, and hence variable loan rates, rise further. "Consequently, investors in these mortgage trusts may receive returns lower than returns on comparable fixed-interest investments, perhaps significantly lower returns after adjustment for risks," IPAC says.

Mortgage trusts are unit trusts that invest mainly in first mortgages over properties. They pay income quarterly or monthly and usually redeem money at short notice.

Mortgage trusts provide a better return than many traditional fixed-interest investments in the medium term. And, unlike many fixed-interest trusts, they are not exposed to capital growth or loss when market interest rates move.

Some mortgage trusts guarantee a minimum rate of return for a certain period in advance. Some are also capital-guaranteed.

Mortgage trusts had a net funds inflow of $440 million in the year to March 1994, according to the latest market share report from IFR Research. Total funds under management passed the $2 billion mark for the first time in four years.

Poor March-quarter returns for bond funds and capital stable funds have sparked even greater interest in mortgage trusts since then.

Mortgage trust investors don't want to be exposed to unit price volatility, says Gordon Bell, associate director at Bleakleys financial planners. They are looking for a higher yield than a cash trust with a bit more flexibility than a debenture, he says.

But IPAC Research is concerned that investors will become dissatisfied with the returns from mortgage funds that have a high exposure to fixed-rate loans and mortgage-backed bonds.

If returns become uncompetitive, there is the risk of increased redemptions, which in turn, could affect the liquidity of these funds, IPAC says.

(Mortgage-backed certificates don't yield quite as much as first mortgages but, because they can be traded on a secondary market, they are more salable. They are not as liquid as cash and bonds.)

The Mercantile Mutual Mortgage Fund No 2 is one fund with a high exposure to fixed-rate mortgages. It aims to have only 15 to 20 per cent of its mortgages on a variable rate at most times.

Paul Scully, the deputy general manager of investment products at Mercantile Mutual, agrees uncompetitive returns could trigger a withdrawal of funds and affect the liquidity of a mortgage fund. But he believes Mercantile Mutual can avoid this situation by keeping an "appropriate balance" between fixed and variable-rate mortgages at all times.

"It is most important to reorganise the portfolio when the interest rate cycle changes," he says. "If cash flow is strong (and interest rates are rising) you can use new cash to buy variable-rate mortgages."

The Heine Monthly Income Fund has about half of its mortgages written on fixed rates at the moment and the manager is quite happy with that.

Marc Mengler, executive director at Heine, says the current rate on a three-year, fixed-rate loan is nearly 3 per cent higher than the variable rate.

It is worth locking in a higher fixed rate and running the risk that the variable rate will overtake it during the fixed term, he says.

Heine predicts only a slow and gradual increase in interest rates and is very comfortable having half of its portfolio "fixed".

Arun Abey, the executive chairman of IPAC, says this could be a "dangerous line" to take. Interest rates could well rise more sharply than expected, he says.

But the strong market demand for fixed-rate loans means several managers are being forced to write at least some fixed-rate business.

For example, the conservatively managed ANZ Mortgage Fund usually has most of its money in variable-rate loans. "But we have increased our fixed-rate lending, mainly because the market has demanded it," says John Meaney, the senior manager of mortgages at ANZ Funds Management. "We were finding it hard to write all variable-rate loans."

Meaney says there's nothing wrong with writing fixed-rate business when interest rates are rising. But it is important to watch the "maturity profile"of the portfolio, he says.

IPAC believes trusts with longer average maturities are less liquid because they are locked into fixed rates for longer and may find it hard to meet a stream of redemption requests.

If a fixed-rate portfolio were skewed towards low rates, the fund also runs the risk of becoming uncompetitive and, in the face of low relative returns, may face a higher level of redemptions, IPAC says.

"If you have constantly maturing loans, the danger of being left behind(when interest rates rise) is not as great," says Brett Howard, managing director of the Howard Group, which manages the Howard Mortgage Trust.

Nevertheless, Howard tends to echo IPAC's concerns about fixed-rate loans and is steering clear of them for now.

"We saw the writing on the wall at least 12 months ago," Howard says. "We have worked hard to write as many loans as possible with a variable rate. Something like 85 per cent of the (mortgage) portfolio is variable-rate."

GLOBAL is another fund manager targeting vari able-rate mortgages in a big way. "Writing fixed (mortgages) is a bit ridiculous because rates will rise and people will stagger behind by 0.5 to 1 per cent," says David Hickie, director of mortgage funds at Global.

But the mix of fixed and variable-rate loans is just one thing to consider when investing in a mortgage fund.

You also need to know who your money is being lent to and how strict the manager's lending rules are. The fund's maximum "Loan to Value Ratio" (LVR)will give you some clue.

The LVR is the amount of a loan expressed as a percentage of the value of the property providing the security. The higher the LVR, the riskier the mortgage.

It's also important to know what sort of property is providing the underlying security, says Robert Keavney, the managing director of the Investor Security Group.

Keavney avoids mortgage trusts that lend against the security of a property development, rather than an existing property asset.

Some mortgage trust managers also stress the importance of spreading their loans, and hence their risk, across different geographic areas and different sectors of the property market.

Next you need to look at the purpose of the loan.

Most mortgage trust managers lend money to investors to buy property, Keavney says.

Others, such as Howard, also lend money for business purposes against the security of the borrower's property.

"Instead of competing with residential investment rates, Howard is competing with bank overdraft rates," Keavney says.

"So you can get a superior return without greatly superior risk," he says.

But Keavney stresses that mortgage trusts should form only part of an investor's overall fixedinterest portfolio.

The cash component of a mortgage fund is another important factor, IPAC says. Funds with a low level of cash may face liquidity problems if there is a stream of redemption requests.

"Almost all investments are prone to trouble in the event of a run,"Keavney says. But at least with mortgage trusts you know what the underlying assets are worth and you know when you can liquidate them, he says.

ANZ's Meaney also points out that a big cash component can be a hindrance to a mortgage fund because it dilutes returns.

HOW MORTGAGE TRUSTS HAVE PERFORMED

Fund Investment Returns to

March 31 (% pa)

6mths* * 1 year 2 years

ANZ Mortgage Fund 6.18 6.65 7.29

Colonial Bricks & Mortar 6.45 6.75 7.28

Global Monthly Income Fund* 8.30 8.65 9.01

Global Mortgage Security Fund 7.11 7.23 7.73

Heine Monthly Income Trust 6.46 6.92 7.80

Howard Mortgage Trust 7.82 8.13 8.80

Mercantile Mutual Mortgage Trust 2 7.31 7.48 7.90

Nat Mutual Australian Income Fund 6.78 7.40 7.58

Nat Mutual Mortgage Common Fund No 1 6.45 6.84 7.63

Perpetual's Mortgage Fund 6.73 7.14 7.79

NB: List limited to funds open to new investment

* Open to existing investors only * * 6-monthly returns converted to annual rates of return.

Source: IFR Research

© 1994 Sydney Morning Herald

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