Interest has waned ... illiquidity is a problem for mortgage trusts. Photo: Tanya Lake
A former must-have investment for seekers of increased yield has become a pariah since the global financial crisis.
Falling interest rates are prompting investors to start looking beyond term deposits and at-call accounts to see if they can find assets that will pay a higher yield, without exposing them to much extra risk. Before the GFC, one of the investments on their shopping list would have been mortgage trusts.
However, mortgage trusts suffered heavy outflows during the GFC, as investors moved their money into guaranteed deposits. Most funds were forced to freeze or limit redemptions.
A Morningstar report published last month suggests things have not improved during the past five years.
''We believe that a mortgage trust is only compelling if there is sufficient premium above cash to justify the additional default risk and illiquidity of mortgages,'' research analyst Alex Prineas says. ''Over most time periods, the mortgage funds we assessed either underperformed the UBS bank bill index or delivered only a minuscule premium for added risks.''
Mortgage funds invest in a portfolio of loans secured by residential and commercial mortgages. Investors are paid a share of the interest on the loans, but face the risk loan defaults will reduce the return from the fund.
In the past, mortgage-fund managers paid redemptions on demand, but mortgages are illiquid assets and since the GFC, standard practice has been to provide only a certain amount of liquidity for redemptions each month or quarter. It can take time to get your money out.
A problem for the sector is that they have been in steady run-off since 2008. Funds under management fell 24 per cent in 2010 and 19 per cent last year. This constant outflow forces managers to hold more in cash than they would otherwise choose, reducing returns.
Morningstar looked at five funds. Three - Balmain Mortgage, Colonial First State Income and Perpetual Mortgage - are closed to new investment and will be wound up.
Of the other two, Prineas gave the Howard Mortgage Fund a negative rating because he considered the arrears rate to be high.
According to the fund's latest monthly report, 2.2 per cent of loans are in arrears. The Howard Mortgage Fund has paid a return of 3.6 per cent over the past year, which is well below what investors would have earned from high-yield savings accounts in the same period.
Morningstar gave the Australian Unity Mortgage Income Fund a neutral rating. However, the fund's September distribution was an annualised rate of 3.45 per cent. Over the past three years it has paid an average rate of 4.8 per cent a year.
SQM Research takes a more positive view. It says the sector has resolved many of the issues around redemptions. SQM increased its ratings for the La Trobe Australian Mortgage Fund.
It is important to note that a number of mortgage funds are classified by Morningstar as ''aggressive'', which means that they might provide property development loans, offer second mortgages, or lend on high loan-to-valuation ratios.
They might offer higher returns, but they also expose investors to higher risk.
In addition to large pooled funds, these companies may also sell investments in so-called contributory mortgage schemes - investors put their money into a single asset.
The difference changes the risk profile of the investment. In a large pool, a bad loan will have a marginal impact on returns, while in a contributory scheme, it might wipe out the whole investment.