27 | 2023 Investment Outlook | December 12, 2022 AGENCY MBS As Investors Shed Risk, Demand for Agency MBS Likely to Pick Up KEY POINTS With the specter of recession and credit defaults on the horizon, money manager 1 demand for agency MBS is set to pick up in 2023. Andrew Szczurowski, CFA Higher-coupon agency MBS yields are now close to 6% for the first time since the Head of Agency MBS, early 2000s. Portfolio Manager 2 To mitigate against the risk to our higher-coupon theme from prepayments in 2023, we 1 3 are moving to specified pools that can offer pay-up convexity on top of attractive spreads. What We Are Seeing ƒ For the first time in over a decade, we expect investors will have to contend with a true credit default cycle in 2023. Under this scenario, bond selection will be critical. ƒ Fortunately, investors are once again receiving attractive yield from high-quality bonds. Fourteen years of central bank policies setting artificially low rates have ended with government- sponsored, agency MBS yields at levels not seen since before the global financial crisis. ƒ In our view, supply of agency MBS is set to fall significantly in 2023, as mortgage rates approaching 7% have dramatically slowed U.S. home sales and eliminated any cash-out refinance supply. ƒ Declining supply in 2023 should more than offset the absence of the Federal Reserve in the MBS market, providing a nice technical tailwind for MBS spreads. ƒ Short duration now means more yield: The Fed’s ongoing battle to cool inflation has led to the most inverted Treasury curve since the early 1980s. Investors can now pick up over 70 basis points (bps) by staying at the short end of the yield curve. ƒ 2022 marked the worst year on record for the MBS market. On the upside, we believe this has created an attractive entry point for intermediate- or long-term investors, as high starting yields and wide spreads have historically preceded periods of strong total returns. What We Are Doing ƒ After spending nearly an entire decade below 3%, higher-coupon agency MBS yields are now close to 6% for the first time since the early 2000s. ƒ We expect mortgage interest rates to decline in 2023 from their two-decade high, as spreads narrow from their 2022 wides. ƒ We continue to believe that the best value in the sector can be found in higher-coupon MBS, which offer an attractive combination of higher yields, wider spreads and shorter durations. ƒ To mitigate against the risk to our higher-coupon theme from prepayments in 2023, we are moving to specified pools that can offer pay-up convexity on top of attractive spreads, which we believe will offer some insulation as mortgage rates decline.