Solid returns from mortgage-backed investments

Sometimes it seems that many of the products in the middle, including corporate debt and the more conservative finance companies get ignored.

One of the things advisers need to think about when putting together the income part of a portfolio is the need to have diversification within it.

With Government bonds it is possible to put a portfolio of NZ Government Bonds (index weighted) will pay you a default risk free return of 5.92% (less any commission).

The reality is there are groups like Equitable and the New Zealand Mortgage Income Trust which provide mortgage-backed investments and solid returns.

When investing in mortgage-backed securities one factor investors need to take into consideration is whether the investment is supported by first or second-mortgage secured finance.

The cost of borrowing second-mortgage secured finance is usually considerably higher than on a first-mortgage basis, reflecting an increased risk premium. This is because when the First Mortgagee seeks to recover their debt through the sale of a security property, they have some significant advantages over the Second Mortgagee. These advantages are outlined below:

First Mortgagee risk

• The First Mortgage holder is first in line for re-payment in a recovery situation.
• The level of debt recovery is dependant on the strength of the security held.
• In most cases 100% of the loan is recovered.

Second Mortgagee risk

• Only after the First Mortgagee has been paid in full will the Second Mortgagee have access to any remaining funds.
• Assessed asset values are usually significantly discounted in a mortgagee sale situation (often by 15-20% or more) prejudicing the Second Mortgagee’s position.
• First Mortgagee’s priority over sale proceeds will include payment of accrued interest (at penalty rates) together with recovery of costs incurred, further eroding the funds available for repayment of the Second Mortgagee.

This is not to say second-mortgage or higher risk lending is bad -– far from it. As long as the lender in question is not overly exposed to high risk transactions and has a spread of relatively modest loans compared to its capital base, a small number of defaulting loans are in themselves unlikely to put the company (and therefore the investor) at risk.

While these more conservative investments alone may not meet all of an investor’s yield expectations, they do help support investment portfolio performance.

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