Australian Finance Group: Clouds building with prospect of rate rises

About the author:

Azib Khan
Author name:
By Azib Khan
Job title:
Former Senior Analyst
Date posted:
28 February 2022, 12:00 PM
Sectors Covered:

  • Australian Finance Group (ASX:AFG) has reported 1H22 NPAT of $30.033m, 0.8% better than we expected. An interim dividend of 7.0cps fully franked has been declared, slightly better than our expectation of 6.7cps.
  • In an environment of elevated refinancing activity – particularly from variable to fixed rate – strong growth in settlements in the aggregation business has provided a hedge to net interest margin softness and faster loan book run-off in the AFG Securities business.
  • Looking beyond FY22, we believe a rising interest rate environment will result in earnings headwinds for AFG through downward pressure on the net interest margin and softer residential settlement activity. We are yet to build any rate rises into our forecasts.
  • Retain Add recommendation. Target price reduced to (login to view).

Aggregation revenue notably better than expected

AFG has reported $30.8bn of residential settlements for 1H22, up 47% on 1H21 and comfortably the best half-year for residential settlements on record. AFG has said that strong settlement activity has been driven by increasing activity in the investor market as well as due to customers upgrading or refinancing.

We believe the strong settlement activity has been largely driven by customers refinancing from variable to fixed rate home loans.

We expect residential settlement activity to remain strong in 2H22F. However, we expect normalisation in activity levels post 2H22 given that the proportion of new home loan flows into fixed rate products is now normalising.

Aggregation strength providing hedge for securitisation softness

Elevated refinancing levels have resulted in a notably faster run-off rate for the AFG Securities (AFGS) loan book in 1H22, as well as resulting in downward pressure on the net interest margin (NIM) through more competitive retention and front-book pricing.

We expect some moderation in the AFGS loan book run-off rate in 2H22, however, we expect the intense downward pressure on the NIM to continue in 2H22.

Clouds building with prospect of rising rates

We expect a rising interest rate environment to result in downward NIM pressure for AFG, initially through the normalisation of basis risk (1-month cash-bill spread) and later potentially through wider RMBS spreads. We see potential for a 25bps adverse impact on AFG’s NIM upon full normalisation of basis risk with all else constant.

Whilst the 1-month bank bill rate is still sitting considerably below the target official cash rate, we believe it may begin the trajectory of normalisation towards being 10-15bps above the target official cash rate once the RBA decides to not reinvest proceeds of bond maturities.

The RBA has said that it will consider the issue of reinvestment of proceeds of bond maturities at its May meeting.

While we expect AFG to try to offset any downward pressure on margins by growing higher margin products, the higher margin products will likely face more RMBS spread widening than lower margin products in an environment where securitisation investors are concerned about the asset quality outlook.

We also expect a rising rate environment to result in softness in residential settlement activity.

Investment view and changes to forecasts

We have increased our FY22F cash EPS by 1.3% largely due to stronger-than-expected residential settlement volumes in the aggregation business.

Our cash EPS forecasts for FY23F/FY24F are reduced by 8.9%/8.7% respectively due to: lower NIM forecasts, lower AFGS loan balance forecasts; and higher expense forecasts.

Our target price, based on our DDM valuation, is (login to view). Retain Add recommendation.

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Disclaimer: The information contained in this report is provided to you by Morgans Financial Limited as general advice only, and is made without consideration of an individual's relevant personal circumstances. Morgans Financial Limited ABN 49 010 669 726, its related bodies corporate, directors and officers, employees, authorised representatives and agents (“Morgans”) do not accept any liability for any loss or damage arising from or in connection with any action taken or not taken on the basis of information contained in this report, or for any errors or omissions contained within. It is recommended that any persons who wish to act upon this report consult with their Morgans investment adviser before doing so.

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