The
MBS marketplace is a breeding ground for the development of new ideas that
enhance portfolio returns. In order to
compete, fund managers employ a variety of new MBS products in their portfolios
each year. Once in a while, however, the
more time-tested simple strategies seem to be those that outperform the
benchmarks best. One of these strategies
is the Mortgage Dollar Roll. Portfolio
managers at Vanderbilt Capital Advisors strategically use the Mortgage Dollar
Roll in order to boost performance in appropriate market environments.
The
Mortgage Dollar Roll can best be explained by example. An investor who wants exposure to the 30 Year
FNMA 5.5% passthrough can obtain it in one of three
ways. He can purchase a 30 Year
specified pool with a 5.5% coupon; he can purchase a 30 Year FNMA 5.5% TBA
position which is delivered to him on the “regular” settlement date for that
month in the form of three pools for each million dollars of face value (hence,
the term TBA implies that the actual pools to be delivered are “to be
announced”); or he can purchase a 30 Year FNMA 5.5% TBA position and instead of
taking delivery, opt to roll the position for one month. The investor who chooses the third option
will enter into a Mortgage Dollar Roll agreement with the counterparty (usually
a broker/dealer) from whom he is buying the
securities. The Mortgage Dollar Roll (or
“roll”) involves the simultaneous purchase and sale of the same security with
two different settlement dates, usually one or two months apart. (In order to keep this discussion simple, we
will assume the settlement dates are one month apart).
In
a Mortgage Dollar Roll transaction, an investor buys the FNMA 5.5% TBAs from a dealer for regular settlement in a particular
month. Up to 48 hours prior to
settlement, the investor may choose not to take delivery of the TBA pools and
roll them for regular settlement in the next month. In executing the roll, the investor sells the
securities that he was to receive from the dealer in the front month for one
price and buys the same securities from the dealer at a lower price for
settlement in the next month. The
difference between the two prices is known as the “drop”. The investor gives up the coupon and principal
paydowns on the security that he is rolling to the
dealer. The dealer, in turn, foregoes
receipt of the funds from those securities for another month.
The
investor decides in advance if the “drop” compensates him enough to do the roll
based on short-term reinvestment rates and his expectation of near term
prepayments. The investor will usually
choose to roll his securities when his expectation of prepayments is high
enough on a security that trades at a premium (or low enough on a security that
trades at a discount) and the reinvestment rate at which he can invest the
funds for that month combined are more economical than taking delivery of the
securities. Therefore, an investor who
chooses to roll a premium issue, for example, eliminates the risk of higher
prepayments during the roll period.
Similarly, an investor who rolls a discount issue removes the risk that
prepayments will decline during the roll period.
The
investor reaps additional benefits from not taking delivery of a TBA
security. When delivering a TBA security
the broker is not required to deliver any pool in particular and consequently
the broker is allowed to deliver a quantity of bonds that is not exactly
identical to the face value of the original trade by +/- 2%. As a result, the broker will always deliver
the quantity of bonds that benefits him and in turn hurts the investor. For example, if the market is higher on the
TBA settlement date than it was on the trade date the broker will likely
deliver 2% fewer bonds than the investor purchased and have the option to sell
those bonds to another investor at the prevailing higher price. Conversely, if the market sells off after the
trade date, the broker will deliver 2% more bonds and lock in a gain on the
additional bonds he delivered to the investor.
On
the flip side, the dealer’s reasons for entering into a dollar roll transaction
are manifold. He may have a short
position in that security and needs to deliver it to another dealer or investor
in the front month. He may be structuring
CMOs from that type of passthrough
and needs it for closer settlement in order to complete his CMO
transaction. His opinion on prepayments
may suggest that taking the opposite side of the roll is actually more
beneficial. Therefore, the roll may be
an economical alternative to both parties.
In
order to highlight a market environment when both parties benefited from the
roll we look at recent history. The
spring of 2003, for example, was a time when dealers offered drops that
compensated investors well for rolling TBAs and, in
turn, benefited themselves. As the
treasury market was rallying, prepayments began to pick up speed and investors
wanted protection from escalating prepays.
As a result, rolling TBAs was one of the
preferred methods of owning mortgages.
At the same time, the steepness of the treasury curve afforded dealers
the opportunity to create very profitable CMO deals. As a result dealers were more than willing to
offer investors great roll opportunities.
Investors chose to roll in order to have an exposure to an outperforming
MBS market without taking on prepayment risk.
Below
we outline an example of how we calculate whether it is economical to enter
into a roll transaction with 30 Year FNMA 5.5% TBAs
or to take delivery of the pools. The
important items to point out are that we assume that FNMA 5.5s will prepay at
20 CPR for the next month and that the reinvestment rate for one month is
0.95%. Note that the
drop that we are offered is 11/32.
After calculating the return from taking delivery of the securities
versus entering into a roll transaction, we decide that it is more economical
to roll the securities. The economics of
this transaction translate into a dollar advantage of $34,912.28, which is
equal to 0.42% of annual incremental return.
I. Assumptions
|
Security:
FNMA 5.5% 30-Year TBA January |
|
Prepayment Rate: 20 CPR |
|
Settlement Date: January 14, 2004 |
|
Current Delivery Price: 102 7/32 |
|
Forward Price: 101
28/32 |
|
Price Drop: 11/32 |
|
Reinvestment Rate: 0.95% |
|
Initial Balance: $100
MM |
II. Return from Holding of FNMA 5.5%
|
A)
One month Principal and Interest received by investor on 2/12/04 |
|
Principal: |
$ 1,945,020.10 |
|
Interest: |
$ 457,508.81 |
|
Total: |
$ 2,402,528.91 |
|
B)
Value of the asset on 2/12/04 |
|
Own $98,054,979.94 principal |
|
|
FNMA 5.5% @ 101-28/32: |
$
99,893,510.81 |
|
+Principal & Interest Rec. |
$
2,402,528.91 |
|
+Acc. Int. (2/1/04 –2/12/04) |
$ 164,786.84 |
|
Total Value on 2/12/04: |
$102,460,826.56 |
III. Return from Dollar Roll of FNMA 5.5%
|
A)
$100MM FNMA 5.5% January TBA @ 102-7/32 for settlement 1/14/04 |
|
Principal: |
$102,218,750.00 |
|
Accrued Interest Paid (1/1/04 –
1/14/04): |
$ 198,611.11 |
|
Total Cost: |
$102,417,361.11 |
|
B)
Invest $102,417,361.11 @ 0.95% for 29 days = $78,377.73 |
|
C)
Value of Asset on 2/12/04 |
|
Money to invest: |
$102,417,361.11 |
|
+29 days int. @ 0.95%: |
$ 78,377.73 |
|
Total Value on 2/14/04: |
$102,495,738.84 |
|
IV.
Evaluation Dollar Roll Value: $102,495,738.84 Holding Security
Value: $102,460,826.56 $ Value advantage of Dollar Roll: $ 34,912.28 32nds Value advantage of Dollar Roll: 1.12/32 34,912.98 / 100,000,000 *32 32nds Value annualized:
13.41/32 Percentage Annual Incremental Return: 0.42% (13.41 * 100 / 32) |
The
Mortgage Dollar Roll is a simple financing opportunity that incorporates the
key element associated with MBS: prepayments.
It offers investors a chance to enhance their returns and protect their
delivery rights by exercising their opinions on prepayments and taking
advantage of the supply and demand relationships in the marketplace.