IRVINE, CA—If interest rates rise, portfolios withadjustable-rate mortgages should provide a higher level of incomefor investors, reports Vertical Capital MarketsGroup. The firm's Vertical Capital IncomeFund outperformed its benchmark once again in the thirdquarter.

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“Like VCAPX, any fund that holds adjustable-rate mortgagesshould benefit from rising interest rates,” GusAltuzarra, CIO for VCAPX, tells GlobeSt.com. “Interestrates for ARMs are at lifetime lows; when interestrates increase, the coupon rate for the ARMs will increaseaccordingly. They will initially trail index values, but they willeventually catch up. As they do, they will provide a hedge againstrising rates.”

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In addition, rising rates are usually closely tied withinflation, Altuzarra adds. “If inflation increases, the value ofthe collateral behind the loans should increase,reducing risk.”

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During Q3 2014, VCAPX declared a dividend of $.1234 and showed areturn of .57%, compared with a .18% return for its benchmark, theBarclays US Mortgage-Backed Securities Index. Thefund has returned 6.28% year-to-date with a $.3895 dividend,compared with a return of 4.22% for the MBS Index. For the one-yearperiod ending September 30, VCAPX produced a return of 7.29%compared with a return of 3.78% for the benchmark MBS index.

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As GlobeSt.com reported in September, VCAPX has become one ofthe first interval funds to exceed $100 million in assets. The fundhas outperformed its benchmark since it wasintroduced in 2011 and has surpassed MBS Index results both at netasset value and at the fund's maximum sales charge from inceptionthrough the second quarter of this year. For the one-year periodending June 30, VCAPX produced a return of 6.79%,compared with a return of 4.66% for the benchmark MBS Index.

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Bayard Closser, president of VCAPX, says hedoesn't expect the Federal Reserve Board toincrease interest rates any time soon, but adds that that the fundcontinues to benefit from lower interest-rate sensitivity than thebenchmark. He says markets are already reacting to a potentialincrease, and when rates rise, his firm's fund could benefit. About20% of the mortgages in the VCAPX portfolio are adjustable-ratemortgages, so when rates increase, rates on those mortgages willreset and may provide a higher level of income.

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In addition, as rates rise, many homeowners with ARMs will seekto refinance, so they can lock in rates beforethey rise too much, says Closser. When mortgages are refinanced,VCAPX will receive payoffs for their full value, which will enablethe fund to capture discounts received when Vertical purchased itsmortgage notes.

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“This 'collateral gap,' which represents the difference betweenwhat we pay for a mortgage note and its ultimate value, now totalsmore than $27.6 million,” says Closser. “As a result, investors maybenefit from a recovery of these funds when interest ratesrise.”

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In addition, he adds that VCAPX's investments are allcollateralized, so if rising interest rates resulted in theforeclosure of any properties in the VCAPX portfolio, the fundwould own the underlying properties. In most cases, property valueshave increased since Vertical purchased the notes. In addition, allnotes in the VCAPX portfolio have been purchased at adiscount—typically about 25% to 50%—so it's likely any foreclosedproperty can be sold at a profit, which would benefitinvestors.

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“VCAPX also has a low correlation to bothequities and fixed-incomesecurities,” says Closser. “As interest rates increase, someinvestors will likely seek alternatives that are less sensitive tointerest rates, and that could also benefit the fund.”

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Carrie Rossenfeld

Carrie Rossenfeld is a reporter for the San Diego and Orange County markets on GlobeSt.com and a contributor to Real Estate Forum. She was a trade-magazine and newsletter editor in New York City before moving to Southern California to become a freelance writer and editor for magazines, books and websites. Rossenfeld has written extensively on topics including commercial real estate, running a medical practice, intellectual-property licensing and giftware. She has edited books about profiting from real estate and has ghostwritten a book about starting a home-based business.