There’s nothing quite like the visual (and visceral) impact of opening up MBS Live in the morning only to see a big drop in the blue line. Today is one of those days. For those who haven’t gotten around to it yet, let’s get it out of the way. The sooner we do, the sooner I can explain why this isn’t as bad as it looks. In fact, it’s not bad at all…
The first clue here is that the chart shows 0-00 as the day-over-day change and he previous close price is the same as the current price (despite the line on the chart looking like it’s MUCH lower than the previous close price). This is not an error. It’s the roll!
The word “roll” has a few meanings around here. For those who participate in MBS markets at a higher level, “dollar rolls” are actual tradeable positions that involve selling one delivery month of MBS to buy a future delivery month (or vice versa). Colloquially, however, we also use the term simply to refer to the monthly settlement process in MBS. Reason being: since the price of a dollar roll is the same as the gap between this month’s MBS and the next, it gives us a quick way to refer to the drop in prices that shows up on charts when we shift our point of view to a new delivery month.
Confused yet? Don’t be. This is as simple as the concept of “time value of money.” For instance, let’s say I have 2 and only 2 MBS coupons to sell you and you have to decide which one you want, as an investor. They’re identical in every way except you’ll get your first interest payment one month earlier on one of them. Which one would you pay more for?
You’d obviously pay more for the one that paid you back sooner–all other things being equal. Granted, there are few additional considerations that can go into the decision, but it’s mainly about the timing of repayment.
Once you understand that, all that’s left in mastering an understanding of price movement on roll day is to consider that yesterday’s MBS prices were for September MBS and as of today, those are no longer being actively traded. If they were, we would see September MBS prices up around 103-09 on the following chart. Instead, we switch our view to the next most current delivery month: October.
October coupons were ALWAYS trading lower in price (due to time value of money). If we could modify the chart above to include October coupon prices, it would look like this:
Bottom line: apples to apples (October vs October), prices were unchanged this morning. It only looks like a big drop if we’re comparing September to October. The day-over-day change on the chart uses yesterday’s closing price for October coupons. Thus, it’s a true indication of the day-over-day change in the MBS market whereas the roughly 20bp drop in price is NOT (again, it was never a “drop” in prices… just the difference between September and October).