Rising Interest Rates Could Benefit Funds

IRVINE, CA—If interest rates rise, portfolios with adjustable-rate mortgages should provide a higher level of income for investors, reports Vertical Capital Markets Group. The firm's Vertical Capital Income Fund outperformed its benchmark once again in the third quarter.

“Like VCAPX, any fund that holds adjustable-rate mortgages should benefit from rising interest rates,” Gus Altuzarra, CIO for VCAPX, tells GlobeSt.com. “Interest rates for ARMs are at lifetime lows; when interest rates increase, the coupon rate for the ARMs will increase accordingly. They will initially trail index values, but they will eventually catch up. As they do, they will provide a hedge against rising rates.”

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

During Q3 2014, VCAPX declared a dividend of $.1234 and showed a return of .57%, compared with a .18% return for its benchmark, the Barclays US Mortgage-Backed Securities Index. The fund 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-year period ending September 30, VCAPX produced a return of 7.29% compared with a return of 3.78% for the benchmark MBS index.

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

Bayard Closser, president of VCAPX, says he doesn't expect the Federal Reserve Board to increase interest rates any time soon, but adds that that the fund continues to benefit from lower interest-rate sensitivity than the benchmark. He says markets are already reacting to a potential increase, and when rates rise, his firm's fund could benefit. About 20% of the mortgages in the VCAPX portfolio are adjustable-rate mortgages, so when rates increase, rates on those mortgages will reset and may provide a higher level of income.

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

“This 'collateral gap,' which represents the difference between what we pay for a mortgage note and its ultimate value, now totals more than $27.6 million,” says Closser. “As a result, investors may benefit from a recovery of these funds when interest rates rise.”

In addition, he adds that VCAPX's investments are all collateralized, so if rising interest rates resulted in the foreclosure of any properties in the VCAPX portfolio, the fund would own the underlying properties. In most cases, property values have increased since Vertical purchased the notes. In addition, all notes in the VCAPX portfolio have been purchased at a discount—typically about 25% to 50%—so it's likely any foreclosed property can be sold at a profit, which would benefit investors.

“VCAPX also has a low correlation to both equities and fixed-income securities,” says Closser. “As interest rates increase, some investors will likely seek alternatives that are less sensitive to interest rates, and that could also benefit the fund.”