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Deciphering the Greek
Now that there are graphs and MBS prices posted periodically,
we've received numerous questions about the significance
of the data. This is intended to be a brief companion to
the daily mortgage rate analysis that
will "get you by" until we release more comprehensive literature
on the topic. To some of you this will be old hat, but I'll
start completely at the beginning so it is accessible even
to the first timer. Keep in mind this will be brutally oversimplified
due to the fact that a more detailed version will be released
at a later date.
What is MBS?
Any time you see me write MBS in this blog, or anywhere
else for that matter, I am always going to be referring
to Mortgage Backed Securities. These are
bonds that have a PRICE and a YIELD just like treasuries.
The PRICE always refers to the cost of buying $100 of that
particular bond. For instance, if the price of a bond is
101.00, then an investor would pay $101.00, and in exchange,
would then own only $100.00 worth of that bond. So why pay
more or less?
In a word: YIELD. Yield is the rate of
return paid on that bond over time. There are multiple different
types of bonds, and each bond has a certain yield that it
pays. You will sometimes hear me refer to yield as "coupon"
or "issue." As you might guess, the higher the yield, the
more the buyer will make over time, so the more the buyer
is willing to pay. For instance, at the very moment this
tutorial is being typed, a certain class of MBS (a bond)
with a 5% yield costs $97.25. So for every $97.25 you spend,
you get $100 dollars of bond, paying you back at a 5% rate
of return. Another bond in the same class with a yield of
6.5% is currently costing $103.10. So you'd have to pay
over the face value to get the $100 dollars to pay you back
at 6.5%. So hopefully this illustrates as we move from coupon
to coupon (i.e. 5% to 5.5% to 6.0% to 6.5%) that the cost
of ownership will get higher, but so will the yield.
Now it gets confusing because all this time I've been telling
you that "as PRICE goes up, YIELD goes down." Well, it does,
but only when we're talking about one coupon at a time.
Talking about the full spectrum of coupon rates
means that naturally the price will be higher when we're
talking about higher yields. But that concept is not central
to bond analysis. We are only ever interest in Price VS.
Yield as it relates to supply and demand, and even if we
are considering several coupon rates, we will only analyze
one at a time.
In this way, when price goes up, yield goes down. Why!?
Because if the bond's coupon rate is 6.5% and the price
drops from 103.10 to 102.10, now the investor that is buying
it gets more for his money, plain and simple. So because
his 1 million dollars now buys almost 1% MORE than it did
at the higher price, the yield on that investment will be
higher as well! If this doesn't click for you, please spend
some time google searching bonds or try PIMCO's Bond
Basics. I'm not saying this to be pedantic or derogatory,
but rather because the concept requires immersion for some,
and there is a definite learning curve that cannot be achieved
simply by trying to digest my definitions. Moving on...
[Part
1] [Part
2] [Part 3]
[Part 4] [Return
to the blog]