Considering Mortgage-Backed Securities? Look for Income, Duration Management

Fixed income investors looking for more yield can opt for mortgage-backed securities with ETFs like the FlexShares Disciplined Duration MBS Index Fund (MBSD).

MBSD seeks investment results that correspond generally to the price and yield performance of the ICE BofA Merrill Lynch, Constrained Duration US Mortgage Backed Securities Index. The underlying index reflects the performance of a selection of investment-grade U.S. agency residential mortgage-backed pass-through securities.

“The index is composed of securities selected from the universe of 10-year, 15-year, and 30-year MBS,” a FlexShares Fund Focus article said. “The index seeks to maintain a monthly effective duration within a one-year band of 3.25 years to 4.25 years—with a midpoint target of 3.75 years. This range was chosen in an effort to help avoid greater turnover than potentially necessary to help maintain the target duration. The index also factors such as current Federal Reserve policy, the outlook for U.S. interest rates and potential reforms of agency mortgage programs.”

As mentioned, MBSD can offer fixed income investors the yield they crave, especially with safe haven Treasury yields as low as they are.

“Many investors look to mortgage-backed securities (MBS) as an option to help diversify their fixed-income holdings and pursue higher potential yields than are available from U.S. Treasuries,” the Fund Focus added. “However, investing in MBS comes with special considerations around duration—a key measurement of a fixed-income security’s sensitivity to interest rate movements.”

Built-In Duration Management

One of the challenges with mortgage-backed securities is being able to effectively manage duration. Too much duration can introduce rate risk, while too little could deprive investors of higher yields.

“An allocation to the MBS segment may help investors diversify their fixed-income holdings with bonds that offer strong credit quality and attractive yields,” the article continued. “However, managing duration positioning in an MBS portfolio can be challenging, as changes in interest rates also can lead to changes in mortgage prepayment levels that may move MBS duration more dramatically than expected.”

This is where MBSD comes into play with its built-in duration management component.

“The FlexShares Disciplined Duration MBS Index Fund (MBSD) seeks to provide exposure to the potential benefits of MBS investing while helping address the challenge of duration management,” the Fund Focus added. “The underlying index’s rules-based approach for managing effective duration within a one-year band around a target midpoint of 3.75 years may lead to less volatility in duration than investors would experience in a traditional market-weighted MBS index—helping investors position MBS exposure more efficiently and effectively within their overall portfolios.”

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