Last rites for mortgage funds?
October 24, 2008
PORTFOLIO POINT: Investors can get better returns from cash in government-guaranteed bank accounts, leaving riskier mortgage funds with a problem.
Mortgage fund investors, with an accumulated $5.5 billion invested in well-known funds woke today to find some of the biggest names in the business, including Axa and Perpetual, had frozen their accounts. The sudden sealing of mortgage funds reveals as much about the Rudd government's sudden decision to guarantee cash deposits in bank accounts as any deep crisis in mortgage funds. Nonetheless, it raises in dramatic fashion, some hard questions that every investor now needs to ask about these deceptively risky products.
Australia is a unique environment for investors in that there have tended to be few really high-quality fixed interest offerings available directly. For example, US investors can invest directly into US backed Treasury Bonds, but not so here.
In Australia, many investors have made use of a variety of fixed interest investments including listed fixed interest securities and mortgage funds. However, now the government has guaranteed bank deposits (including term deposits, online accounts and saving accounts), these bank deposits effectively carry the AAA-rated government guarantee. They are as good as a risk-free investment.
That has reduced the attraction of some of the other fixed interest investments that have been being used in portfolios. Because of that investors, quite understandably, have been trying to withdraw their funds from mortgage accounts to deposit them into AAA cash accounts and term deposits. This inflow to bank-based cash accounts has been directly at the expense of now-frozen mortgage trust accounts at Australian Unity, Axa, Challenger Howard and Perpetual.
The problem the sudden outflow of funds raised is that the underlying assets of the mortgage funds - the mortgages - often have a reasonably long time to maturity, and the fund is not "liquid"; that is, the money is not immediately available for investors. For example, the Perpetual Monthly Income Fund has 57.2% of its assets held in mortgages (and the Wholesale Mortgage Fund 52.7%), of which 42% of the mortgages have a maturity of more than two years.
The Challenger Howard Mortgage Trust has about 90% of its investments in mortgages, with an average term to maturity of just over two years.
Both Challenger and Perpetual, along with other mortgage fund managers, have had to put stops on redemptions to try and cope with investors looking to take their money from the mortgage into the new world of AAA-rated bank accounts.
The return from these funds provides a window into why it is happening. To the end of September, 2008, the UBS bank bill index had provided an average return of 6.69% a year over the past three years. The Perpetual Wholesale Monthly Income Fund's annual return over the same period was 6.3% and Challenger Howard Mortgage Fund's return was 6.96%. For one year, the Perpetual fund's return was 6.4% and Challenger's 7.64%.
These returns are certainly sound but they are not that different to a cash-like return that an investor can now access for considerably less risk.
It should be noted that these investments have done what investors would have expected: providing a reasonably reliable investment return over the past three years, including during the "volatile" past 12 months.
The story for existing investors
These style of funds (mortgage funds) are often used in portfolios, and many investors will be exposed to them. (As a point of disclosure, I do not use mortgage funds in any of my clients' portfolios).
The most pessimistic of people with these now frozen mortgage funds might be wondering whether they are looking at the massive problems faced by Westpoint, Fincorp and Bridgecorp investors. The positive news is that this seems highly unlikely.
In looking at the portfolio summaries of both the Challenger and Perpetual funds, the loan portfolio are completely different from those previously mentioned (Westpoint, Fincorp, etc): they are well diversified, have modest loan to value ratios, are well diversified and the funds have strong histories of repaying investors.
Keep in mind that the Westpoint et al disasters were based around:
- Second mortgages (mezzanine finance).
- Often related party loans.
- Loans for property construction.
- Poorly diversified portfolios
It seems reasonable for investors to be confident about the underlying portfolio supporting the Perpetual and Challenger investments.
That said, the change that sees bank deposits become AAA-rated investments makes bank deposits comparatively more attractive than mortgage trusts, and I think that many existing mortgage fund investors will struggle to think of compelling reasons why they should not withdraw from the mortgage funds as soon as they can and replace the mortgage funds with term deposit and cash investments.
Is this the death of mortgage funds?
The challenge for mortgage funds is to justify their existence in a world of completely safe bank deposits.
It seems to me that the only way they will be able to compete with this will be to offer a yield above what an investor can receive in a cash account. Clearly, mortgage funds are riskier than a AAA investment (such as a cash account), so unless they offer a superior return it seems unlikely that they will find favour with investors.
There are a couple of ways that the funds might improve returns to investors. The first is that they may reduce their fees, which would effectively increase the return of the mortgage funds. The second, that investors should be aware of, is that mortgage funds may be tempted to take on riskier loans to try and increase the interest earned from the money lent out. This may not be in the best interest of investors.
That said, we can never be sure what decisions investors will make. These Challenger and Perpetual funds have been around for a very long time and are likely to have built up high levels of investor satisfaction and loyalty.
The reaction of investors to the government guarantee of bank deposits seems entirely rational: let's take our money out of the mortgage fund and place it into a cash-style investment that pays a similar return, with less risk.
The AAA guarantee for bank deposits only lasts for three years at this stage, so perhaps high-quality mortgage funds will make a comeback at that time.
Listed fixed interest securities in a world of AAA bank deposits
Just as the "introduction" of AAA-rated bank deposits has put pressure on the mortgage funds, listed fixed interest securities also seem less attractive to investors. Consider the WBCPA notes issued by Westpac. These notes had an A+ Standard & Poor's rating and had mainly traded at $102-103 since its listing earlier this year. They are now trading at just over $100.
When they were issued a Westpac deposit (cash account) carried an AA rating. Now, with the guarantee, a Westpac deposit carries an AAA guarantee. This makes the listed fixed interest security comparatively less attractive, and makes the fall in price understandable.
Other longer-term listed fixed-interest securities have fallen in price because of changes in fixed interest markets. As new fixed interest investments have offered higher interest rates above target rates (such as the 90-day bank bill rate) to attract investors during this credit crunch, older fixed listed fixed interest securities offering lower rates of return have become comparatively less attractive, and have fallen in value.
AAA-rated banks with a government guarantee have subtly changed the fixed interest investment landscape. Both mortgage funds and listed fixed interest securities now seem comparatively less attractive than cash accounts. Not surprisingly, mortgage fund investors are heading for the new safety of cash, and listed fixed interest securities have fallen in value. Under present arrangements, it is difficult to see how mortgage funds can return to favour.