Shares in Northern Rock, the mortgage lender, tumbled yesterday after it told investors that it was being hit by rising interest rates.

Adam Applegarth, the chief executive, tried to offset the tide of “sell” orders by promising a “notable hike” in the dividend next month, but the shares still ended the day 12 per cent down.

The Newcastle-based lender said that profits this year would grow by only 15 per cent, rather than the average of 17 per cent forecast by City analysts.

The comparatively sluggish growth rate would continue into 2008, it said.

Northern Rock has been hit by the time lag between agreeing fixed-rate mortgage deals with borrowers and hedging itself in the derivatives market. This hurts it in periods of rising interest rates.

Mr Applegarth predicted that there would be two more rises in base rates this year, but argued that they were not necessary. He urged the Bank of England’s Monetary Policy Committee to exercise caution.

Only about a third of the ultimate impact from rate rises already announced had so far been felt because so much borrowing was on fixed rates, he said.

Around £480 million was wiped from Northern Rock’s value. Its shares have fallen by one third from their peak in February, making it one of the worst-performing FTSE 100 shares this year.

Mr Applegarth told The Times, “It looks a tad harsh, I have to say. The market knows we get squeezed when interest rates rise.”

He suggested that nerves over sub-prime lending in the United States and HBOS’s campaign to win back mortgage market share may also have soured sentiment. He hinted, however, that investors would be pleased with the size of the interim dividend, to be announced on July 25.

A shift in balance sheet strategy, also announced yesterday, increased the scope for dividend increases and share buybacks.

Northern Rock said that it planned to hand more cash back to shareholders through dividends and buybacks as a result of rejigging its balance sheet to suit the new Basel II supervisory regime Analysts had been pencilling in a total dividend increase this year of 19 per cent to 43p. That would put Northern Rock on a prospective yield of 5.1 per cent.

Instead of after-tax profits of £430 million this year, £420 million was more likely, Mr Applegarth said.

The combined effect on net interest revenues of rising interest rates and the reduction in interest income because of asset disposals would be about £180-200 million.

Northern Rock has a long-term goal of lifting profits by 20 per cent a year, plus or minus 5 per cent.

The low-cost mortgage lender is retaining about 85 per cent of its customers as they come to the end of their lock-in periods, helping it to clinch a 19 per cent net share of the mortgage market so far this year. About 75 per cent of its mortgages are fixed rate.

In future it will sell on higher-risk loans, such as unsecured debt and commercial mortgages to third parties, while continuing to originate and service them.

Mark Thomas, analyst with Keefe Bruyette and Woods, played down the seriousness of the warning, saying it reflected “period-specific strain” and did not indicate any problem with the underlying business model.

The bank revealed that it had already begun its shift out of higher-risk lending, completing the sale of £838 million of commercial mortgages to Lehman Brothers last week. It has also conditionally agreed to the sale of a further £732 million loan book, to be completed in the second half of this year.

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