23rd January 2008
Recent years have seen an explosion in the offerings of mortgage funds. As well as the more traditional first mortgages over property assets, many of the newer funds also invest in what's called 'mezzanine' debt (second mortgages), and lend for riskier construction financing. In recent years, more of these mortgage funds at the higher-return, higher-risk end of the lending spectrum have appeared, which in the following discussion we'll call 'high income' mortgage funds as a shorthand, to distinguish them from the more traditional 'senior/conservative' mortgage funds, or those which invest primarily in first mortgages.
It's worth keeping these distinctions in mind when considering the historical returns provided by mortgage funds. As a group, retail funds produced an average return, net of ongoing fees, of 6.72 percent over the year to 30 June 2006, and a three year net return of 5.87 percent. However, if we look at our two groups of mortgage funds separately, the 'senior/conservative' funds produced three and five year net returns of 5.29 percent and 5.12 percent respectively, but the 'high income' mortgage funds - those which have a high proportion of their lending to riskier second mortgages and construction development - produced higher average net returns, for the same two time periods, of 8.44 percent (three years) and 7.95 percent (five years). The returns from the 'high income' mortgage funds were also more volatile than their 'senior' counterparts (although the difference was not substantial in an absolute sense).
While we can understand the difference between 'conservative' and 'high income' mortgage funds from what they invest in, and how they've performed as a result, there's no such clear distinction when it comes to the ongoing costs of investing in these funds. If you're expecting to pay less for exposure to the less risky 'conservative' mortgage funds, but more for the higher-return, higher-risk 'high income' funds, you can forget that idea. There's no such clear dichotomy among our retail mortgage funds - you can pay as high as 2.28 percent per annum for one of the lower-risk 'senior' options, and as little as 0.76 percent per annum for one of the higher-risk 'high income' options. (Keep an eye out for performance fees, too - although they're not as prevalent here as they're becoming with share funds, several mortgage funds available to retail investors do have them.) The average ongoing fee for retail mortgage funds is currently 1.45 percent each year.
And so we come to the principal risks with investing in mortgage funds. In general terms, funds which have a high proportion of lending, as second mortgages, (also referred to as mezzanine or subordinated debt) over properties are deemed to be more risky. First mortgages are generally deemed safer, because the lender of the first mortgage is the first in line to be paid if the lender defaults, and the underlying property has to be sold.
A major correction in property market conditions, leading to changes in property asset valuations, is another risk associated with mortgage fund investing. This can be particularly damaging for mortgage funds lending against development projects. Readers with long memories may recall the example 15 years ago of the Estate Mortgage Trusts, where investors ceased receiving income payments, their assets were frozen, and many investors never recovered their initial investment. A number of factors contributed to the demise of the Estate Mortgage Trusts. Of particular note was the willingness to lend money against valuations that reflected the top of the market, high fees paid to the manager, and an increased exposure to higher-risk development projects, which gave rise to liabilities the trusts were ultimately unable to fund.
Mortgage funds are also susceptible to movements in interest rates. The degree of impact will depend on whether or not the fund manager has lent money on a fixed or variable basis. Even if the loans are based on a variable rate, there will typically be a lag between when interest rates rise, and when that increase can be passed on to borrowers and in turn, reflected in the income paid from the mortgage fund. Higher interest rates also put pressure on a borrower's ability to meet repayments, which may lead to higher defaults.
Another important potential risk with mortgage fund investing is the soundness of the investment lending practices and parameters, and whether these are applied consistently. Among possible problems are overdependence on a single property valuer (which is why most mortgage fund managers rotate property valuers, to ensure diversity of appraisals), and poor documentation and process in lending practices, which can lead to inconsistent application of lending guidelines and parameters, such as checks on creditworthiness. It's also possible for a mortgage fund manager to have related party risk, where a fund manager lending over properties owned or managed by an associated party - such as another company within the same group - may engage in inappropriate lending practices or investment behaviour.
Inappropriate marketing and promotion is another possible area of concern. The Australian Securities and Investments Commission placed a final stop order in October 2005 on the product disclosure statement for a Gold Coast-based fund, on the grounds that it lent substantially to property developers for construction projects, but that the product disclosure statement was not disclosing the high default rate, and was using language and statements designed to give the impression of low risk and security. Issues like these can increase the 'unknown risks' inside a mortgage fund.
Concentration in a particular property asset, sector of the property market, or geographical area or region is another potential mortgage fund risk. This is because it increases the potential damage caused by a downturn in economic activity and property values in that sector or region, and also increases the likelihood of the borrower being unable to make their regular repayments. (Again, this is why many mortgage fund managers have rules and practices restricting maximum investment in any one property asset, area or development project.) By way of example, a mortgage fund which lends primarily over Queensland properties is more subject to the risk of a downturn in the Queensland property market affecting the mortgage fund's ability to make its regular income payments to its investors, than a more geographically-diversified fund which lends across more than one of the states.
When any of these risks surface, there is the possibility that assets in a mortgage fund may be frozen for a period. While the returns from mortgage funds appear on the surface to behave similarly to cash funds - and mortgage funds are often sold to investors as a slightly higher risk alternative to bank term deposits and cash funds - the underlying assets in mortgage funds cannot be sold as quickly as a bank bill. This potential liquidity risk is why many mortgage funds carry the right to impose exit fees in certain instances, and the right to suspend redemptions for a period of time.
There are fewer of these high-yield funds than for the other income product groups. The average return from high-yield funds net of ongoing fees over the year to 30 June 2006 was 5.77 percent, and over the three years, 7.92 percent. As with other mortgage fund options, ongoing costs of investing in high-yield funds vary widely.
The major risk for these high-yield funds is credit risk - the ability of the organisation issuing the debt security to meet its repayment schedule, and where the debt security ranks in the hierarchy of repayment. Many of the debt securities in which the high-yield funds invest, sometimes known as ‘mezzanine’ or ‘subordinated’ debt, lie between traditional debt securities and equity ownership in the company itself.
In the event of the company striking difficulties making its debt repayments, these 'mezzanine' securities are generally lower in the hierarchy of debt repayment. This is why investors demand a higher return for their riskier investment, in the form of higher yields. Fund managers should, however, through prudent selection and sound diversification from among the available opportunities and industries, be able to reduce the impact on an overall portfolio - and therefore on both an investor's capital invested, and income stream - of a default by any of the
higher-yielding debt securities in which the fund is investing.
A related risk for high-yield funds is interest rate risk. If interest rates rise substantially, the borrower may struggle to service the higher interest costs on their debt, increasing the possibility of defaulting on their debt repayments. Because the higher-yielding securities are 'subordinated' or second-tier debt, they rank below other forms of debt on the repayment ladder, and so their repayment may be jeopardised.
One final issue worth thinking about here is what we have dubbed 'product complexity risk'. This is the risk that funds which invest in complicated and sophisticated debt arrangements such as these may become too complex for the people managing them to understand fully all the embedded and associated risks, which may lead to unintended risks to either the investor's capital, or income stream, or both.
Morningstar's Six Rules of Thumb for Investing in Income-Oriented Funds
By keeping these rules of thumb at the forefront of your mind, you'll be able to make more informed assessments of the key characteristics and risks involved.
- Higher-returning income products do carry more risk, and should be assessed on the basis of how the investment manager is seeking to manage that risk.
- Just because a new product sounds different does not mean that it can escape the ups and downs of investment markets.
- The level of diversification within different income funds can vary substantially, and can be lowest where needed most. This is particularly the case for newer products investing in a narrow part of the income securities market.
- Different income funds will behave differently in different economic and financial conditions, highlighting the need for diversification in any portfolio.
- The regular income payments from mortgage funds are attractive, but do not always reflect the risks beneath the surface of some funds.
- Don't let high returns fool you into forgetting the basics. Investing funds in a range of income product groups and managers helps to diversify the overall portfolio.
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Head of Funds Management
t +61 3 8610 2811
Chris Andrews is the Head of Funds Management for the La Trobe Group and has responsibility for the La Trobe Australian Mortgage Fund.
Read full profile here.
La Trobe is one of Australia's leading independent specialist mortgage Financiers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Mortgage Funds under AFSL 222213. It employs over 115 staff and has raised over AUD$10Billion to assist over 100,000 customers since inception in 1952.
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