Top agency MBS buyer talks value at the start of 2023

Brendan Doucette is a portfolio manager with GW&K Investment Management, based in Boston, which manages around $5bn in taxable fixed income assets. Of this, some $1.4bn is invested in the agency MBS market.

SCI caught up with him last week to see how he views the market and likely developments at the start of 2023.

Q: Hi Brendan, nice to talk to you again. Where do you see value in agency MBS at the beginning of this new year?

A: Well, last year owning what the Fed didn’t paid off and I expect this will continue. By owning what the Fed did not you have higher coupon pools, meaning they have inherently lower rate and spread duration. So, when rates sold off more than the market expected and MBS spreads blew out due to quantitative tightening, what you owned outperformed the MBS Index and sometimes had positive returns to Treasuries. Nominal spreads are still two standard deviations wide of the longer term mean, so we still see value in agency MBS.

Q: What impact did rate hikes have on the agency MBS market last year, and how will that continue this year?

A: Earlier last year, spreads moved out a long way due to QT and lack of bank demand, but from about the middle of the year became correlated with rate volatility – which was back to pandemic highs. This was volatility induced by the Fed and weighted towards the front end of the curve. Our view is that as the Fed slows rate increases, volatility will fall. Rate vol has already come in quite a long way since October and with it MBS spreads have narrowed. Nominal spreads are about 45bp tighter in the last three months. We expect this to continue in 2023, though as spreads are now at the low end of the range there could be some volatility. But, in the longer term we still like agency MBS.

Q: Which areas of the curve do you think will perform the best?

A: We like the higher, newer production coupons, and we’re still underweight the lower coupons. Some of the 30-year 2% coupons are trading with an $83 handle on them, which obviously looks good because they’re so heavily discounted. But what you’re hoping for there is faster prepayments, and from a fundamental perspective prepays have continued to slow due to the decreased affordability of homes, lower sales and lower refinancings. When bonds are so deeply discounted, spreads can widen significantly when prepayments are lower than markets anticipate.

The Fed owns a lot of paper which securitized mortgages in the 2.5%-3% ranges, when rates were at the lows of the cycle. Since then, rates have touched 7% so there was significant extension in duration and no natural buyers.

Q: There was a rather abrupt shift from QE to QT, rather more abrupt than the market expected I think. Has that been absorbed by the market?

A: Yes, I think it has, and the technical picture is  improving. With mortgage rates now sharply higher, we’re going to have lower refinancing, lower turnover in the housing market, lower origination and less supply. The non-organic supply from the Fed has also slowed. Their monthly cap is $35bn and we’re seeing less than half that at the moment.

Q: How much supply are you expecting to see in 2023?

A: Estimated net supply is $250-$300bn this year. This compares to $450bn last year and $850bn in the previous year, so that is a significant drop off.

Q: There is still the possibility of rate-based volatility this year isn’t there?

A: Yes, very much. There is a dislocation between what the Fed is saying about where rates are going to be and what the market is actually pricing in. There’s not necessarily a difference on what the terminal rate will be, but more on whether the Fed will cut rates later in the year.

Q: Making homes more affordable is clearly a priority of the FHFA, and the GSEs have announced initiatives to help underserved borrowers. Are you worried that a widening of the credit box will hurt credit quality of the collateral?

A: No, not really. Right now home prices are relatively high and mortgage rates are also high so what the GSEs and FHFA are doing isn’t really going to increase affordability. In the future it could, but I’m not expecting much of an impact in 2023. There’s also data which suggests borrowers with a lower credit quality actually have better convexity profiles than someone who could more easily refinance their mortgage, so I’d be more worried about deterioration in the TBA market from higher conforming loan limits than widening the credit box.

What would sound the alarm bells is a significant amount of poor quality loans followed by a disruption of the housing market, turning into delinquency and faster prepayment speeds. As you know, in the agency MBS market we only care about rates, not credit, and that would be our worry. But I think there is more risk from higher conforming mortgages in 2023.

Q: Any other thoughts?

A: I think specified pools will be well supported this year. They’re now included in the MBS Index, which is one factor, but as conforming loan limits were set higher at $726,000 at the end of 2022 - an increase of $79,000 –this makes them more vulnerable to interest rate risk. There might be higher turnover and higher prepayments, so your way round that is to buy specified pools.

Q: How much spread tightening could we see in Q1?

A: Well, it’s difficult to say Simon. We’ve rallied 45bp since October so we’re a bit vulnerable right now. I think the long term mean is perhaps 30bp inside where we are now, but I’m not sure when or if we get there. We’ll see what happens with Fed rates and vol.

Simon Boughey