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Check Your Duration Risk as Inflation Reaches New Four-Decade High

·2 min read

This article was originally published on ETFTrends.com.

Inflation in the U.S. reached 9.1% in June, the largest 12-month increase since the period ending November 1981, the U.S. Bureau of Labor Statistics reported today.

The Consumer Price Index for All Urban Consumers (CPI-U) increased 1.3% in June on a seasonally adjusted basis after rising 1.0% in May, according to the Labor Department. June’s inflation print surpassed May’s annual rate of 8.6%, leading Federal Reserve officials to shift to a faster pace of benchmark interest-rate increases, according to meeting minutes released last week, per the Wall Street Journal.

The increase was broad-based, with the indexes for gasoline, shelter, and food being the largest contributors. The energy index rose 7.5% over the month and contributed nearly half of the all items increase, with the gasoline index rising 11.2% and the other major component indexes also rising. The food index rose 1.0% in June, as did the food at home index.

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, according to FlexShares. However, investing in MBS comes with special considerations around duration, which is especially relevant as the Fed raises rates at a faster pace.

Historically, duration — a key measurement of a fixed-income security’s sensitivity to interest rate movements — has been a major driver of MBS risk and returns, and investors must continually monitor the effective duration of an MBS portfolio due to the impact of mortgage prepayments.

A fund to consider in the current environment is the FlexShares Disciplined Duration MBS Index Fund (MBSD), which is designed to provide market-like exposure to the MBS segment while controlling for potential duration drift. The Fund tracks the ICE BofAML Constrained Duration US Mortgage Backed Securities Index, which follows a rules-based approach to maintain the portfolio’s duration within a target range.

The index is composed of securities selected from the universe of 10-year, 15-year, and 30-year MBS. 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 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.

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