It's Check-up Time For Loan Funds

Sydney Morning Herald

Saturday February 17, 2007

Simon Hoyle.

With rate rises starting to bite, it's good policy to ensure those mortgage investments are sound, writes Simon Hoyle.

AS CRACKS start to appear in property markets, and interest rate rises cause an increasing number of foreclosures and forced sales, investors in mortgage funds are well advised to do a quick check on their investments.

When you invest in a mortgage fund, you effectively take on the role of lender. A mortgage fund pools your investment with the money of other investors, and then lends the money out. The fund charges interest to borrowers, takes a slice for itself, and passes the remainder back to you in the form of income.

Interest rate rises should - other things being equal - lead to a rise in the income your investment earns. But if rate rises also mean that people you've lent money to can't service their debts, you have a potential problem.

You might find yourself in the same position as any lender - bank, credit union, mortgage originator - with bad debts, facing the potential loss of some of your capital.

Problems in the residential property market will affect a mortgage fund only if it lends money on residential property; most lend only a small amount of total funds to the residential sector if, indeed, they lend any at all.

But residential borrowers are not the only ones affected by rising interest rates. In a report released earlier this month, ratings firm Standard & Poor's warns that "loan defaults are becoming more prevalent" among mortgage funds, which means some funds are beginning to find some borrowers are having trouble making repayments. However, it notes that as yet, "few losses have been incurred".

The S&P findings do not suggest that mortgage funds no longer play a role in a diversified investment portfolio, nor that the sector is about to be hit by widespread defaults. Rather, it should be a catalyst for mortgage fund investors to double-check they know what they have invested in, what their money is being used for, and the associated risks. The risks now clearly include a higher possibility of loan defaults.

These sorts of risks were brought home to investors in one fund, the LM First Mortgage Income Fund, during 2006, when the fund's loan arrears - that is, mortgages on which repayments are late - hit a peak of 16.5 per cent. LM had lent money to the failed Westpoint group of companies. The manager of the fund, LM Investment Management, has managed arrears back down to less than 5 per cent since then, and S&P says the level is expected to fall further.

"LM has also been closely managing its liquidity to continue to meet forecast distributions, loan-funding obligations, and redemption requests," S&P says.

The LM experience served as a timely reminder that while well-managed mortgage trusts are relatively secure, problems can sometimes arise. And problems are not what investors in mortgage trusts expect or want. Generally, investors are looking for a solid, reliable income stream.

"For the more conservative mortgage funds, regular income is the key to it," says Peter Ward, associate director of fund ratings at Standard & Poor's. "Distributions [of income] are generally on a monthly basis. There are some funds that are a bit more high risk - the high-yielding funds that still pay out distributions on a monthly basis, but they have a higher proportion of [property] development risk in them."

Ward says a reasonable expectation for income from a mortgage fund is something above the standard income fund benchmark, the UBS Bank Bill Index. Funds lend money on either a fixed-rate or variable-rate basis. If a fund lends on a variable rate, rises in interest rates tend to flow through to investors more quickly than if it lends on a fixed rate. But rate rises hit borrowers more quickly, too.

Ward says most mortgage funds - the traditional, more conservative ones, at least - are struggling to meet the performance benchmark. He says banks have become more aggressive lenders, and started to compete more directly with mortgage funds.

In the words of one manager quoted in the S&P report, banks and mortgage funds are "milking the same cow". It's making it more difficult for mortgage funds to find the kinds of borrowers they need to beat their traditional performance benchmark.

It makes it all the more tempting for investors to turn to funds offering a higher yield. But a higher return equates to a higher risk. And investors should remember the lessons of history, says Roy Prasad, head of mortgages at Australian Unity Investments (AUI).

"History shows that, in times of economic downturn, it is the products that offer the very highest returns that are most likely to collapse first.

"Such products therefore carry the greatest risk, something that some investors may conveniently ignore at their peril.

"Returns are likely to increase in 2007 anyway, through rising interest rates, but wise investors will avoid being overly greedy and ignore products that give three or four [percentage] points above the average returns.

"But even with mortgage funds, it is sensible to choose a highly rated, well-managed fund with a consistent performance track record - although keep in mind that past performance is no guarantee for the future.

"Investors should also make sure they understand what constitutes a good quality fixed income-earning trust, and the difference between conservative and high-yield mortgage products, so they can better understand the risk profile in a particular fund, not just focus on returns.

"The Westpoint scenario is a clear example of risk being overlooked by people looking for a very high income return."

To get a handle on what to expect from a mortgage fund it is important to "look at the objective of the fund", says Grant Harris, manager of the Premium Income Fund for MFS Investment Management.

"The objective will give you an insight into expected risk and return through the economic cycle: is the fund's objective input-focused, like a Dalek that can only say one word: 'Mortgages! Mortgages! Mortgages!', or is it investor-outcome focused, [focused] on delivering a target rate of return to the investor from a diverse portfolio of assets?

"Look at the risk premium above cash - is it sufficient for the additional risk? Currently you can get more from ING Direct than some mortgage funds.

"Look also at the lending policies of the fund and its geographical and sector exposures - they will be critical in times of rising interest rates."

S&P's Ward says investors in mortgage funds can avoid the worst of any bigger problems that could emerge in the residential property sector if they understand how the fund they have chosen (or are considering) generates its returns.

"The things to look at are where the income stream is coming from - what sort of loans the mortgage fund offers, and whether they are to income-producing properties," Ward says.

"We can ask the question with regard to whether there's a residential portfolio within the broader loan portfolio, and whether those loans are income-producing or non-income-producing.

"Investors should enquire as to whether there have been any loan losses, and what the level of arrears are.

"Just about all the mortgage funds would put out monthly or quarterly reports which have details of the sectoral and geographic diversification in their portfolios. That's something else that needs to be looked into."

Keep your heart rate down - tick these boxes

1. If returns seem too good to be true, they probably are"I believe that double-digit returns from mortgage funds are very difficult to justify," says Roy Prasad, head of mortgages at Australian Unity Investments (AUI). "In order to produce returns of 10 per cent a year - or higher - the risk involved far outweighs the returns for investors."

2. The "loan to valuation" ratio (LVR) should be appropriateThe LVR should be no more than 70 per cent for conservative funds and 85 per cent for high-yield funds, Prasad says. This ratio compares the value of all loans against the value of all properties in the fund, and should be provided in the fund's product disclosure statement (PDS). The lower the ratio, the greater the comfort zone for investors, should problems arise.

3. Check your entitlementsPrasad says conservative mortgage funds hold only first mortgages, but more risky funds, such as mezzanine funds, invest much more in second mortgages to produce a higher rate of return. He says that in the latter case investors rank further down the list of creditors if anything goes wrong, and run a higher risk of not getting their money back.

4. Consider the spread of loansIf a fund allocates 50 per cent or more of the portfolio to construction and development loans, then alarm bells should sound, Prasad says. "In the current property climate, these types of investments are very risky," he says. "A well-balanced mortgage fund should also have a spread of loans against different property sectors - including residential, commercial, retail and industrial - as well as good geographic spread in different capital cities and major regional centres."

5. Check what the experts sayResearchers are a reliable source of useful information about a product. "They also rate products to help investors compare similar funds, such as mortgage funds," Prasad says.

Source: Australian Unity Investments

© 2007 Sydney Morning Herald

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