- 10yr Notes progressively improved into the PM , ending 5 ticks better on the day with a yield of 3.70.
- MBS fought off much of the AM weakness in tsy's, and rallied just as well into the PM, reaching 101-15 at 4pm.
- But then we ended 4 ticks down on the day at 101-01! WHAT?!?!?
So you're tellin' me MBS effectively erased all gains from the past two days?!
Not exactly...
I'll let AQ explain...
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If you haven't read the following description of the agency MBS settlement
process...please don't skip over it as it may save you from having to change
your pants when next month's settlement rolls around. If you have read it...go
over it one more time just to make sure the underlying logic is clear.
The March FN 4.5 MBS coupon has begun the settlement process. The FN
4.5 price seems like it has fallen from 101-13 to 101-01.
WHY???
The MBS coupons that determine your rate sheet pricing are traded in the TBA
MBS market...
TBA = To be Announced.
In the TBA MBS market, at the time a trade is made, buyers and sellers agree
to a few specific terms like what coupon, the issuing agency (Fannie, Freddie,
Ginnie), size of trade, and a buy/sell price....the actual pools of loans are
NOT exchanged at the time of this commitment. Instead, the MBS buyer and the
seller make an agreement to complete the transaction at a later date. In the
MBS market this date is pre-determined....it is called SETTLEMENT DATE (clever
name huh?). Agency MBS trading settles once a month. For instance we have been
watching the March MBS coupon trade since February 9. As of tomorrow
morning, we will be watching the April FN 4.5 MBS coupon until April 9,
2009. HERE IS THE CALENDAR
We can actually watch forward pricing as much as three months
ahead...SEEEEEE:
Anyway...two days before the pre-scheduled settlement date, the MBS seller
"notifies" the MBS buyer of the specific pools that they will deliver
to satisfy the previously agreed upon terms of the trade. The MBS buyer then
reviews the pool information to ensure that the seller is delivering loans that
meet the agreed upon terms (which were determined at the time of the trade).
Two days later, on settlement date, funds are wired and the trade is complete
(it goes deeper...this is the outline of the trade).
But why do prices seemingly fall when the current delivery month comes to
an end on notification day?
Prices don't really fall...we just start watching next month's MBS coupon
because last month's coupon is settling. The forward month coupon price
remains the same. Below is the current April settlement FN 4.5 MBS
coupon...currently costing buyers 101-00 (if you bid with size). This is where
prices will seem to fall later this afternoon.
I KNOW I KNOW...in your eyes prices are lower. Let me explain the reason
why prices fall when we start watching the forward month coupon.
The main reason behind the price "DROP" is lost time value of
money.
Interest rates can be thought of in three ways..
1. Required Rate of Return: this is the minimum amount of
return an investor is willing to receive when making an investment.
2. Discount Rate: the rate used to determine the present value of
future cash flows. When you loan someone money with the intention of being paid
back in the future, you must place a value on how much of a premium you are
losing by not spending that money right now. The discount rate is essentially
how much you are charging to delay repayment until a future date.
3. Opportunity Cost: the value an investor passes up when choosing an
alternate investment. You must earn enough interest when you loan someone money
to compensate for the loss of income that you could have been earning by
investing elsewhere.
That said...would you rather have $1.00
today or $1.00 tomorrow?
You would rather have $1.00 today! If you have $1.00 today you can invest it
today...the fact you are investing today vs. tomorrow implies you are giving
the asset more time to appreciate.
Now to relate this concept to the MBS market...if you buy the March FN 4.5
coupon, then your returns will begin accruing on March 1. If you
buy the April coupon...your returns don't start accruing until April 1
(even if you buy it tomorrow)
Investing now puts money to work now. Waiting until April means the
investor is missing out on accrued interest they could be earning right
now. To compensate for the lost Time Value of Money you demand a higher
yield....which means lower MBS price.
Note: to be clear, the previous owner has rights to the income
(accrued interest) earned from while they owned the coupon. The price you pay
to purchase the back month coupon includes the income the current owner has
accrued while they owned the coupon. The buyer recovers the added premium
when the coupon payment is deposited in their account. This is called the
'clean price'...it's the same way Treasuries trade.
So hopefully, ignoring that last "Note".....a light bulb just went
off in your head.
Plain and Simple: If you own the March MBS coupon, then
you are entitled to the coupon clips (income) paid in March, this income is
generated from the underlying loan's principal and interest (passed through
from borrower to MBS investor). If you decided to wait to roll to April before
buying an MBS coupon (which you can do today in after hours trading)...then you
have to wait until April for your investment to start accruing income....so
to compensate for the lost "time value of money" ..investors demand
higher yields, which is why prices fall when delivery rolls forward to the next
month.
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Thanks AQ. As far as tomorrow, gameplan remains unchanged with a majority of focus on the 10yr note auction at 1pm, especially in light of a relatively data-free Wednesday morning.