UK Mortgages feels impact of falling interest rates – UK Mortgages says that, for year ended 30 June 2019, its NAV fell from 85.7p to 82.1p, its share price fell from 87.25p to 73.5p and it cut its dividend target from 6p to 4.5p. The main culprit for this is said to be falling interest rates.
Within its mortgage origination businesses, TML’s first securitisation (where the returns from a portfolio of mortgages are sold off in tranches of decreasing seniority, with UK Mortgages keeping the highest yielding but riskiest part) was achieved in April 2019 and Keystone is building towards its inaugural securitisation, probably in the first half of 2021. In April, they refinanced Malt Hill No. 1, their original Coventry Building Society portfolio and this pool is now held in a warehouse facility (a vehicle that holds portfolios of debt before it is securitised).
Medium term interest rates fell in the second half of the period, as the broad economy slowed and Brexit uncertainty persisted. In particular, 2-year swaps fell from 1.157% to 0.835% between the end of 2018 and the end of June 2019 and 5-year swaps fell from 1.298% to 0.898%. By the end of July, 5-year rates were slightly lower than 2-year
swaps.
As these lower forward rates were incorporated in UK Mortgages’ revenue models, along with the realised proceeds of the TML securitisation and the Malt Hill No. 1 refinancing, it became clear that full coverage of the 6p annual dividend would take longer than anticipated at the time of the interim report and continuing to pay an uncovered dividend – thereby eroding the NAV – wasn’t a good idea. As a result, the board reduced the annual dividend to 4.5p and at the same time put forward proposals to amend the investment policy to allow the manager greater flexibility when financing portfolios and managing free cash, but without compromising the credit quality of the underlying mortgage pools. These proposals were overwhelmingly approved by shareholders at an EGM in August.
The board has committed to using future excess cash to buy back shares rather than sanctioning new investments, if the company’s shares are trading on a discount greater than 5%. The refinancing of Oat Hill No.1 in May 2020 is likely to be the first point at which surplus cash will be released, but current estimates of this surplus are from GBP30m to GBP50m.
For accounting reasons, the fair market value of the company’s mortgage portfolios is higher than their carrying value, which is based on their amortised cost over the life of each pool. Consequently, this difference does not form part of the NAV and is only realised when underlying mortgage loans are repaid and whenever the portfolio is refinanced. In the case of Oat Hill No. 1, the combination of the unwinding of the purchase discount and lower refinancing rates mean that the fair market value of this pool represents a significant portion of the overall difference.
Following refinancing, the Oat Hill portfolio will continue to generate an income, albeit a relatively modest one as the loans are low-yielding, but this will be higher relative to the capital employed than in the previous securitisation as they expect to use more debt in the structure.
UKML : UK Mortgages feels impact of falling interest rates