Mortgage fund managers have put investors on notice that the structure of their funds will have to change to correct a mismatch in their assets and liabilities.

Most of the mortgage funds in the market are offering their investors only limited redemption facilities as they struggle to deal with abnormally high redemption requests.

Fund managers have the structure of their funds under review and once the present situation is resolved they will make changes.

The most likely change is that mortgage fund investments will be offered on fixed terms. How this will go down with investors remains to be seen.

Mortgage funds have been a popular source of income for many years. They have combined the advantages of a liquid investment, with investors' funds at call, with stable income derived from secured first mortgages.

The problem with the structure is mortgage funds provide loans to small commercial borrowers on terms that have an average maturity of about three years. Their assets have a medium- to long-term maturity while their liabilities (their commitment to meet redemption requests) have been short term.

In most circumstances the funds have had sufficient liquidity (a combination of new money coming in and loans paid out) to meet redemption requests.

But last October, at the height of the global financial crisis, the Government introduced a guarantee on deposits held by banks and other approved deposit-taking institutions. Investors moved a lot of money out of non-guaranteed investments into savings accounts and term deposits.

Mortgage funds were hit by this "flight to quality" and did not have enough cash to keep up with redemption requests. The managers were forced to place restrictions on redemptions or freeze them altogether.

The funds are still frozen. The investment industry research group Morningstar has published a list of 25 frozen mortgage funds, including the largest funds in the sector the Challenger Howard Mortgage Fund, the Axa Australian Monthly Income Fund, the Australian Unity Mortgage Income Trust and the Perpetual Monthly Income Fund.

Most funds are offering quarterly redemptions paying out their available cash on a pro rata basis.

The chief executive of Perpetual, David Deverall, says his group's $2 billion Monthly Income Fund, which is meeting redemptions on a quarterly basis, allocated $80 million to redemptions in December and $70 million in March.

It was able to pay investors about 25 cents in the dollar each time. Deverall says redemption applications were higher than the group had expected.

Australian Unity is paying redemptions monthly, allowing investors to withdraw a minimum of $1000 or up to 1 per cent of their investment in the Mortgage Income Trust. The fund has maintained its normal monthly income distributions.

The head of mortgages at Australian Unity, Roy Prasad, says: "The liquidity levels in the fund have stabilised, allowing us to introduce this capped monthly redemption policy.

"We believe it strikes a balance between giving our investors improved access to their capital while at the same time allowing us to continue managing the fund appropriately for all investors."

The monthly redemption facility applies to Australian Unity's Monthly Income Trust but not to its High Yield Mortgage Trust, which has a quarterly redemption facility.

Fund managers say the underlying assets of their funds are performing well. The mortgage fund sector provides finance to small commercial borrowers.

Deverall says credit quality in portfolios is holding up well, as most mortgage fund managers are conservative lenders. "We are very comfortable with the quality of the assets," he says.

The chief executive of Balmain Funds, John Thomas, says that apart from its liquidity problems the sector is in good shape. All the funds operated by Investment and Financial Services Association members have maintained their $1 unit price.

Thomas says: "All the IFSA mortgage funds have continued to pay their regular distributions."

Morningstar data shows funds have paid returns in a range between 5.5 per cent and 7.8 per cent over the past year. The highest returns over the year to the end of March were from the Mariner Wholesale Mortgage Trust and the Richmond Mortgage Fund.

The biggest fund in the sector, the Challenger Howard Mortgage Fund, paid 7.49 per cent to wholesale investors and 6.81 per cent to retail investors.

At a briefing held by IFSA last month, managers said their structure of funds was under review.

Thomas says the way forward for the sector is to offer mortgage funds as a fixed-term investment. "If we do that the next time a financial crisis comes along we will be better placed," he says.

"We have been road-testing this idea with the financial planning community. So far the feedback is good."

IFSA is hoping to get some Government support for the sector and has been lobbying Canberra, asking it to make temporary investments in mortgage funds through the Australian Business Investment Partnership (the so-called Rudd Bank). The deputy chief executive of IFSA, John O'Shaughnessy, says: "A lot hinges on the Government deposit guarantee. We want to see it wound back and we want to see some stimulus directed to this sector."

FROZEN MORTGAGE FUNDS
Fund Name                               Net Assets $m   Total Return 1 yr %     Total Return 3 yr % pa
Challenger Howard Wholesale Mortgage Fund       1512.86                 7.49            7.05
AXA - Wholesale Australian Monthly Income Fund  1298.16                 6.81            6.88
Challenger Howard Mortgage Fund                 1141.25                 6.81            6.53
Australian Unity Mortgage Income Trust          925.58          6.21            6.16
Perpetual Wholesale Monthly Income Fund 898.57          5.70            6.04
City Pacific First Mortgage Fund                877.00           ???            ???
Colonial First State WS Income Fund             799.29          0.18            3.71
Colonial First State MIF Income Fund            792.67          6.23            5.94
AXA Australian Monthly Income Fund              646.64          6.27            6.35
Australian Unity Wsale Mortgage Income Trust    625.42          6.78            6.69
Perpetual Income Series - Monthly Income Fund   556.82          5.26            5.59
Australian Unity High Yield Mortgage Trust      393.77          6.10            7.02
Australian Unity Wsale High Yield Mortgage Trust        246.27          6.76            7.57
ING Mortgage Trust No. 2                        174.45          5.69            5.72
AXA Generations - Australian Monthly Income     137.17          6.25            6.31
ING Monthly Income                      136.42          5.49            5.54
Colonial First State MIF Income Fund - NEF      132.29          5.81            5.53
Colonial First State Income                     104.50          -0.71           2.79
Mariner Mortgage Trust Wholesale                94.53           7.79            7.32
Mariner Mortgage Trust                  74.89           7.67            7.30
Richmond Mortgage Fund                  71.89           7.79            7.43
AXA Wholesale Australian Income Fund            71.60           6.15            6.02
Perpetual Mortgage                      19.49           5.41            5.66
Colonial First State Guaranteed Mortgage Fund   14.26           6.01            6.03
ING Mortgage Fund                               13.81           5.41            5.42
PERFORMANCE DATA TO 31-MAR-09 SOURCE: MORNINGSTAR