Recently interest rates have gone up. Your customer, Mr. Corelli, has asked you how this will affect the value of his mortgage fund. What is the best response to give to Mr. Corelli?
A.
The mortgage fund will not be affected because the rise in interest rates will affect only new mortgages
B.
The value of the mortgage fund will go down because new mortgages will pay higher interest than those in the fund
C.
The mortgage fund will not be affected because mortgages do not react to changes in interest rates the way bonds do
D.
The value of the mortgage fund should go up because mortgages will now be earning higher interest
Fixed-income securities, including mortgage funds, decrease in value when interest rates rise because existing mortgages with lower rates become less attractive compared to new, higher-yielding mortgages. The feedback from the document states:
"Fixed-income securities move in the opposite direction to market interest rates… Let’s assume you are the fund manager for a mortgage mutual fund, which has mortgages paying 5%. If mortgage rates suddenly increase to 6%, only the interest rates on newly negotiated mortgages would increase… The investor would not pay you par for a 5% rate. If you wished to sell the mortgages, then you would have to lower your price until the price paid—given the 5% fixed payments to be made—results in a return to the buyer of 6%, the ‘going rate’ on mortgages. In other words, the market value of your par value mortgages must fall."
[Reference: Chapter 11 – Conservative Mutual Fund ProductsLearning Domain: Analysis of Mutual Funds, , , , ]
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