Interest in mortgage-backed securities has surged in recent months as investors try to squeeze more yield out of their portfolios.
While interest is surging in the current environment, investors have looked to the diversification and income-generating potential of MBS for many years. Historically, these securities have offered a mix of attractive yields and strong credit quality, according to FlexShares.
While an allocation to the MBS segment may help investors diversify their fixed-income holdings with bonds that offer strong credit quality and attractive yields, 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.
Getting exposure to MBS through an ETF such as the FlexShares Disciplined Duration MBS Index Fund (MBSD) can provide exposure to the potential benefits of MBS investing while helping address the challenge of duration management.
Duration measures sensitivity to a change in interest rates. Bond prices typically fall when rates rise. The higher the duration, the more volatile the expected change, according to VettaFi.
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, according to FlexShares.
MBS returns move inversely to other fixed income asset classes making them a great way to diversify the fixed income sleeve of a portfolio. For most fixed income securities, as interest rates rise, prices decline, and as interest rates fall, prices increase. However, MBS valuation can be affected by borrowers’ prepayments and changes in the level and speed of repayment. The prices of agency MBS tend to rise as interest rates rise when prepayment levels are low, and decline when interest rates drop and prepayments are higher.
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