Diversify Income and Get More Yield With Mortgage-Backed Securities

With inflation continuing to rise in concert with yields, the fixed income environment gets even more challenging. However, there are ways for investors to get yield, such as through mortgage-backed securities (MBS).

Mortgage-backed securities represent a pool of mortgages where investors can earn a return based on the interest the mortgages offer. As opposed to buying the MBS directly, there’s an easier way via the FlexShares Disciplined Duration MBS Index Fund (MBSD).

Packaging mortgage-backed securities in an ETF wrapper allows investors to easily get MBS exposure with the ability to buy or sell the ETF on an exchange. MBSD seeks investment results that generally correspond 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 fund generally will invest under normal circumstances at least 80% of its total assets in the securities of the underlying index and in “TBA Transactions” representing securities in the underlying index.

As mentioned, investors have the ability earn a return on the pool of mortgages within the fund’s holdings. In the case of MBSD, the fund offers a distribution yield of 2.65% (as of February 4) that’s paid on a monthly basis.

“An allocation to the MBS segment may help investors diversify their fixed-income holdings with bonds that offer strong credit quality and attractive yields,” a FlexShares Fund Focus says. “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.”

Higher Yields Ahead for MBS?

Higher yields could be ahead for MBS investors, especially with a housing market underpinned by tighter supply. In the meantime, interest rates are heading higher, which could tamp down demand for mortgage bonds.

“Less demand for mortgage bonds means issuers must offer higher yields to attract investors. So lenders have to raise interest rates on the mortgages inside those bonds,” a Wall Street Journal report notes. “Already, the 30-year fixed mortgage rate is around its highest level since the beginning of the pandemic.”

“As the purchases wind down, it will disproportionately hit demand for MBS,” said David Battany, executive vice president for capital markets at Guild Mortgage Co.

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