VCIF: Good Relative Performance During The Bond Bear Market

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Written by George Spritzer, co-produced by Alpha Gen Capital

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VCIF Logo (VCIF Web Site)

(Data below is sourced from the Vertical Capital website unless otherwise stated.)

Some investment highlights of the fund are:

  • The Vertical Capital Income Fund (NYSE:VCIF) invests as a secondary market participant in the one-to-four family residential whole loan market only. This market offers a deep roster of institutional participants, along with a diverse universe of sellers.
  • The Fund primarily invests in mortgage notes secured by first liens on residential real estate. They only invest in “whole loans” and do not invest in any tranches of RMBS.
  • Investing as a first mortgage lender in whole loans allows the Fund to deal directly with any delinquent borrowers. They can decide on a case by case basis how best to work with a borrower to secure repayment. This has been a significant benefit when the Fund has to deal with borrowers affected by Covid-19, hurricanes, floods or fires.
  • VCIF differs from other mortgage funds because they own the servicing rights on their loans. This allows them to asset manage every single loan.
  • The Fund generates monthly cash distributions from interest earned on the Fund’s loan portfolio, net of operating costs.
  • The Fund also generates capital gains when it sells loans at a price above its adjusted cost basis or when loans originally purchased at a discount pay off in full prior to maturity.

VCIF Loan Breakdown

1) “Scratch and Dent”: Loans that have fallen out of a previous sale to a government agency or have been required to be repurchased. These loans become ineligible for purchase by the agency or primary investor for a wide variety of reasons like a minor guideline miss, first-payment defaults or valuation discrepancies.

2) “Non-QM”: Any loan which does not meet government standards of a qualified mortgage. These loans give lenders more flexibility in underwriting guidelines to work with borrowers.

3) Re-performing Loans: Mortgages that became delinquent in the past but are now current on payments. Often, these loans have been modified from the original terms.

4) Short-term: Mostly bridge and rental loans. Typically have one to five year terms.

Loans can be performing, re-performing (loans that were non-performing at one point and have now become performing), long-term, short-term, fixed rate or adjustable.

The portfolio manager of the fund is Katherine Hawkins. Ms. Hawkins is a senior VP of Oakline Advisors, LLC which advises VCIF. She is an accomplished buy and sell-side investment professional with over 15 years of experience in the residential mortgage market. She is skilled in relationship building, loan analysis and pricing as well as growing investment opportunity pipelines.

The official NAV for VCIF is reported monthly on the Fund web site. As of May 31, 2022, the last NAV reported was $10.78. But CEFConnect shows more recent NAV updates. The last reported NAV shown on CEFConnect is $10.74 as of June 24, 2022.

The current discount on CEFConnect is reported as -13.87% compared to the 6 month average discount of –10.44%. (Source: CEFConnect)

Portfolio Statistics (as of May 31, 2022)

Number of Whole Loans= 739

Total Unpaid Balance(UPB) = $129.4 million

Average UPB per Loan = $175,152

Total Collateral (Real Estate) Value= $197.51 million

Average Collateral (Real Estate) Value per Loan= $267,261

Weighted Average Loan to Value = 65.54%

Weighted Average Acquisition Discount= 11.04%

Weighted Average Interest Rate= 6.52%

% of Performing Loans= 89.97% (<60 days past due)

Weighted Average FICO Score= 668

When I published my last report on VCIF, the Weighted Average Interest Rate was 6.12% as of January 31. In just four months, that rate has gone up 40 basis points to 6.52%. The Weighted Average FICO score increased from 663 to 668.

The average FICO score for the VCIF mortgage loans is below the national average partially because management may allocate up to 10% of the portfolio into loans that were sub-prime at the time of origination. They can look at each loan individually, and may be able to find some that are incorrectly priced.

Table of Percentages

Geographic Breakdown of Loans (VCIF Web Site)

Managed Distribution

VCIF uses a Managed Distribution Plan. Under the plan, VCIF pays a minimum monthly distribution at a stated annual rate as a percentage of the 3-month average net asset value. These payments started in January, 2021.

The table below shows the monthly distributions since the beginning of 2021. The Fund paid a larger year-end distribution of $0.1819 in December 2021.

Distribution Ex-Date

Payment Date

Amount

06/16/2022

06/30/2022

$0.0721

05/17/2022

05/31/2022

$0.0731

04/18/2022

04/29/2022

$0.0742

03/18/2022

03/31/2022

$0.0749

02/14/2022

02/28/2022

$0.0757

01/18/2022

01/31/2022

$0.0765

12/17/2021

12/31/2021

$0.1819

11/16/2021

11/30/2021

$0.0778

10/18/2021

10/29/2021

$0.0784

09/17/2021

09/30/2021

$0.0788

08/18/2021

08/31/2021

$0.0789

07/19/2021

07/30/2021

$0.0790

06/17/2021

06/30/2021

$0.0786

05/17/2021

05/28/2021

$0.0786

04/19/2021

04/30/2021

$0.0788

03/18/2021

03/31/2021

$0.0795

02/12/2021

02/26/2021

$0.08

01/15/2021

01/29/2021

$0.08

The NAV curve for VCIF tends to be more stable when compared to other more leveraged fixed income closed-end funds. The chart below shows the year-to-date graph of NAV and market price.

Performance graph

Price versus NAV graph (cefconnect)

VCIF has strong relative long-term performance compared to its Peers.

Growth of $10,000

Relative performance (morningstar)

Source: Morningstar

Recent performance has been excellent on a relative basis. Morningstar’s YTD ranking puts VCIF in the top 1% compared to its peers.

VCIF: Year-To-Date Performance

VCIF (Market price) -5.68%

VCIF (NAV) -1.21%

Category (NAV) -13.41%

Index (Price) -11.15%

Percentile Rank 1%

Source: Morningstar Category: Intermediate Core Bond

Year To Date Total Returns

Chart
Data by YCharts

Interview with Portfolio Management Team

A few months ago, I spoke with the VCIF fund management on a 30 minute conference call. I thought I would repeat the question on how higher inflation would affect the fund, since it has become even more relevant now.

The high turnover of the fund’s loan portfolio has been useful, since the weighted average interest rate has increased by 40 basis points since the end of January.

– How will higher inflation or a flattening of the yield curve affect the future performance of the fund?

Katherine Hawkins said that the fund’s loan portfolio tends to turn over quite frequently for various reasons – people moving or upgrading their homes, loan refinancing, etc. As new loans are added to the portfolio, they would tend to have higher interest rates when there is higher inflation.

She also pointed out that the valuation of an individual loan depends on many factors, not just interest rates. Examples are collateral evaluation, loan age, terms, borrower debt-to-income, borrower employment status, borrower FICO store, prior credit events etc.

NAV Correlations

I looked up the NAV correlations of VCIF versus several other closed-end funds and ETFs. The correlations tend to be low with traditional asset classes – both stocks and bonds. Because of this, VCIF can provide good diversification for a traditional portfolio.

VCIF versus DMO 40% Western Asset Mortgage CEF

VCIF versus PCF 32% High Income Securities CEF

VCIF versus WIA 30% Inflation-linked Treasury Income Fund

VCIF versus PSLV 28% Sprott Physical Silver CEF

VCIF versus SPY 10% S&P 500

VCIF versus MORT 4% Mortgage REIT etf

Source: cefanalyzer, cefdata

Potential Activist Activity

On February 22, 2022, the VCIF Board announced it has engaged Ladenburg Thalmann & Co. to evaluate strategic alternatives for the Fund, with the goal of increasing shareholder value.

According to nasdaq.com, institutions currently own about 56% of the fund’s shares outstanding which is up from 50% in February. Some of the large investors are well known closed-end fund activists. The share ownership of the top five owners is listed below next to each activist firm as of March 31, 2022.

1) Relative Value Partners Group, LLC- 1,761,593 shares ($16.2 MM)

This investment advisory firm is run by Maury Fertig who was a bond trader at Salomon Brothers in the 1990s. The firm invests actively in closed-end funds. On February 14, 2022, Relative Value submitted a new 13D SEC filing which made it clear that they could still consider some form of future activism:

2) Saba Capital Management, LP 729,560 shares ($6.70 MM)

Saba Capital are well known closed-end fund activists.

3) Bulldog Investors, LLP 606,323 shares ($5.57 MM)

On March 21, 2022, Bulldog submitted a new SEC 13D filing. In the SEC filing, Bulldog submitted another letter to Vertical Capital Income Fund management. I have excerpted the key sections of the letter below:

Dear Mr. Eigenbrodt: In consideration of announcement issued by the Fund on February 22, 2022 that it has engaged Ladenburg Thalmann & Co. Inc. to evaluate strategic alternatives for the Fund, with the goal of increasing shareholder value, we hereby withdraw the proposal we submitted in a letter dated January 18, 2022 requesting that the Board of Directors adopt a plan that would allow shareholders to realize a price for their shares that is at or close to net asset value. Very sincerely yours, /S/ Phillip Goldstein

4) Almitas Capital- 546,229 shares ($5.02 MM)

Uses fundamental and statistical analysis to find securities trading at discounts to intrinsic value throughout the world.

5) Thomas J. Herzfeld Advisors- 390,830 shares ($3.59 MM)

Invests in securities that trade at a discount to intrinsic value. Would normally support closed-end fund activists.

6) SIT Investment Associates- 377,676 shares ($3.57 MM)

Invests in discounted closed-end funds and would normally support activists.

VCIF, Vertical Capital Income Fund

  • Total Investment Exposure= $118.5 MM
  • Total Common Assets= $111.5 MM
  • Effective Leverage = 5.88%
  • Annual Distribution Rate= 9.41%
  • Dividend Frequency= Monthly
  • Current Monthly Distribution= $0.0731 per share ($0.8772 annually)
  • Baseline Expense ratio= 2.48% (omits interest expense)
  • Discount to NAV= -13.69%
  • 12 month Average Discount= -9.94%
  • Average 3 Months Daily Trading Volume= 17,556 shares
  • Average 3 Months Daily $ Volume= $160,000

Sources: cefconnect, Yahoo Finance

Summary

In the current low interest environment, it is hard to find safe fixed income investments which generate a decent yield. VCIF owns first mortgage residential whole loans and is very transparent. This is quite different from a Pimco fund, which are often difficult to understand because of all of the derivatives that they use. With VCIF, there are no fancy derivatives or complex mortgage tranches.

The fund trades at a 13% discount and because of the managed distribution policy, it pays out a distribution yield of 9.33%. The NAV has dropped somewhat with the spike in interest rates, but has been much more stable when compared to its mortgage peers. There is some interest rate sensitivity, but other factors related to the individual borrowers of the mortgage loans are also important factors in the NAV valuation.

VCIF can be used to park cash for awhile, as long as you can withstand some volatility in the market price which tends to vary a bit more than the NAV. There is also a good possibility of future shareholder friendly actions by the fund, such as a tender offer near NAV or a possible conversion to an ETF format. Ladenburg Thalmann has been looking into various ways to improve shareholder value.

VCIF trades around 18,000 shares a day. Care must be taken when executing orders since the bid-asked spread can be quite large. I definitely would recommend using smaller size limit orders. To accumulate a larger position, simply break up the large order into multiple smaller orders. This works fine, as long you use a broker with zero commissions.

For those in a higher tax bracket, it is best to own VCIF in a tax deferred retirement account. Most of the recent distributions have been categorized as investment income or long term capital gains.

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