Dollar rolls, or simply “rolls,” represent a subsector of the TBA market that facilitates simultaneous transactions across delivery months. Trading a dollar roll means buying (or selling) a TBA contract for a given product and coupon and simultaneously selling (buying) a TBA for the same product and coupon but a different settlement month. Roll prices reflect both the difference in economic value between different settlement months as well as technical factors impacting supply and demand across settlements. While rolls are available in most forward and futures markets, the structure of the mortgage and MBS markets makes trading in dollar rolls especially convenient and useful.
This commentary will serve as an introduction to the dollar roll market. We start by defining the market’s protocols and terms, and address how lenders and investors each utilize the market. We then discuss the economics of roll transactions, with a detailed analysis of how values are calculated and how to use the roll calculator in Thomson Reuters Eikon. We also address how carry on MBS is calculated, as certain types of transactions are valued in a similar fashion to rolls. We conclude with a discussion of the technical factors impacting roll levels.
Dollar Roll Basics
Before discussing dollar rolls, it will be helpful to first review the nature of the TBA market, the main venue where MBS are traded. TBAs represent forward contracts for different MBS products and coupons to settle in future months. TBA markets are available for 30- and 15-year Fannie, Freddie (Gold) and Ginnie I and II (multi-issuer) fixed-rate pools. The seller does not need to notify the buyer of the identity of pools to be delivered against an open commitment until 48 hours prior to settlement (the so-called “notification date”). The settlement calendar and delivery rules are created by SIFMA (the industry governing body).
Dollar rolls represent transactions where TBA contracts for the same product and coupon, but different settlement months, are simultaneously bought and sold. Rolls can be traded for any settlement dates, but the bulk of transactions are for one-month horizons for the three settlement months shown on standard trading screens. (See Display 1 for an example of a TBA screen.) Roll prices are quoted for the “front roll” and the “back roll,” in this case the November/December and December/January rolls.
A typical roll transaction might reflect buying (selling) the earlier or “front” month TBA and simultaneously selling (buying) the later or “back month” contract. The “drop” is the difference in price between the earlier and later month, and the term suggests that TBA prices generally decline as settlement is pushed forward into the future, representing the net loss of economic value that would otherwise be garnered by holding the pools for the period in question. (In commodities markets, prices often rise as settlement is pushed forward; called “contango,” this reflects the fact that commodities don’t pay interest but incur storage costs.) Roll trades are very close to duration-neutral, although they are not riskless; as we will discuss, drops are impacted by changes in both financial and technical conditions.
The ability to trade rolls gives additional flexibility to MBS market participants, allowing them to better manage the risks and exposures dictated by their unique production cycles and take advantage of attractive funding opportunities. Trading in rolls takes place to accomplish a variety of purposes. For example, CMO desks often buy rolls in order to obtain pools as collateral for newly issued transactions. Rolls are also purchased by originators looking to push their hedges further into the future if loans are funded at a slower than expected pace. Conversely, investors often sell rolls (by selling the front month and buying the back) to take advantage of favorable financing opportunities available through the roll market. Essentially, the investor is buying MBS in the form of a derivative and letting it accrete higher as time elapses; as settlement approaches, the investor sells the roll and repeats the process. Originators will also sell rolls if their loans are being funded faster than expected and then can efficiently delivery newly created pools against their TBA transactions.
Terms and Conventions
As noted, the drop is the difference in price between settlement months, and represents the pricing of the roll. The earlier settlement month is referenced as the “front month” and the later is considered the “back month.” The “market drop” is the price quoted in the market for a roll. In Display 1, the Fannie 3% roll for November to December (i.e., the “Nov/Dec” roll) is quoted in 32nds at 6.25 bid/6.375 offer. A quoted roll price may materially differ from the “break-even drop,” which represents the economic value of holding the pools over the horizon period (i.e., the time between settlement dates). Participants will also quote a roll’s “break-even financing rate,” which represents the rate at which the position is effectively being funded given the market drop. Thomson Reuters’ Eikon also calculates a “break-even CPR,” which is the speed that equalizes the market and break-even drop given some cost of funds. (As we will discuss, the three critical variables in roll valuations for a given horizon are the drop, the financing costs, and the prepayment speed.)
Investors and traders often compare the break-even roll calculations to market assumptions (i.e., either the market drop or the prevailing short-term funding rate, such as 1-month LIBOR). The comparison is considered favorable if the market drop exceeds the break-even drop or the break-even financing rate is lower than the market rate. In that case, the roll is considered “special,” a term borrowed from the repo market.
Dollar Roll Economics
Dollar roll calculations establish break-even values for different variables over the horizon period, which typically (but not always) are bounded by SIFMA-designated good-day settlements for TBAs. Determining the break-even values for the roll over a horizon period means calculating the levels at which the trader would be indifferent between:
- Buy the TBA in the front month, taking delivery of MBS pools, accept all cash flows due to the holder of record as of month-end while financing the purchase over the horizon period; or
- Buy the TBA in the back month, at the lower price.
As discussed previously, the three critical variables in the calculation are the drop, the financing rate, and the prepayment speed; in order to calculate the break-even value of one factor, the other two must either be observed or assumed.
The following discussions will describe the calculation of roll break-evens for Fannie 3% TBAs for the Nov/Dec 2016 roll (11/14/16 and 12/13/16 being the actual settlement dates), as shown in Display 2. The initial calculations will assume:
- Front- and back-month market prices of 102-26 and 102-20 and a market drop of 6/32s;
- An assumed COF of 0.53378%; and
- A prepayment assumption of 6% CPR.
Let’s first discuss calculating the break-even drop. The initial step is to compute the front-month cash investment as well as the cost of holding and financing the pool. The total proceeds invested for the purchase of 1mm face value of Fannie 3% TBAs (labeled “Notional”) are $1,029,208. (We will truncate pennies for all calculations of proceeds.) For the 29 days of the horizon period, the position costs $442 to hold at the assumed financing rate. It is labeled in the display as “Interest Earned,” although it’s more accurately described as the cost of funding the purchase. The cash outflows total $1,029,650, as shown in the column labeled “Roll.”
Turning to the back-month cash flows, the present value of the principal and interest earned as the holder of record as of 11/30 (labeled “FV Payments” in the display) is $9,146, which will be paid on (or around) 12/25. The value represents the 30 days of interest due the holder as well as scheduled and unscheduled principal paid to the holder using the 6% CPR assumption. The cash flow is discounted for the 12 days between the payment and settlement dates at the 0.53378% financing cost. The sale proceeds in the back month are the assumed RPB of 993,351 times the price of 102-20 ($1,019,426) plus 12 days of accrued interest ($993) for a total future value (“Total FV”) of $1,029,566. The difference between the two different cash flows is roughly $84, or 0.27 ticks on the 1mm original face value. This means that the market drop is about a quarter-tick special; subtracting that amount from the market drop of 6/32s gives a break-even value of 5.75 ticks (shown in the display as 0-056).
A simple adjustment needs to be made in order to compute the break-even financing rate of the roll at the market drop of 6/32s. The financing rate is iteratively adjusted to change the “Interest Earned” component such that the two cash flows are equal (i.e., both are $1,029,566). That rate is 0.43295% in Display 2, slightly lower than the assumed financing rate, also indicating that the roll is trading slightly special. A similar methodology is used to calculate the break-even CPR, forcing the “specialness” of the roll to 0/32s and iteratively changing the CPR until the front- and back-month cash flows are equivalent. (Note that changing the CPR impacts both the FV payments and the proceeds.) In the display, the break-even CPR is 2.47%.
Impact of Different Factors on Rolls
We will now examine the impact of changes to the three key inputs on the economic value of the rolls. With respect to the cost of funds, an increase in the assumed financing rate serves to lower the break-even drop. This is largely because the higher financing rate increases the costs associated with buying and holding the MBS (i.e., the front month cash flows). Put differently, the more it costs the buyer to fund the purchase over the horizon period, the higher the back-month price (and the lower the drop) will be in order to equalize the two cash flows. This is clearly shown in Display 3, where the financing cost is increased to 5.0%. The main consequence is that the “Interest Earned” field increases from $442 to $4,145, although it is partly offset by a lower FV (due to discounting the principal and interest cash flows received at a higher rate).
The impact of changing prepayment speeds depends largely on the dollar prices of the TBAs. When the TBAs are at a premium, the net effect is that more principal is received on the payment date (i.e., in the back month), and as a result the RPB (and trade proceeds) in the back month are lower. This is illustrated in Display 4, which shows the roll run at the same levels but boosts the CPR to 20%. While the “FV Payments” is greater (as more principal is paid to the holder on the payment date), the remaining balance of the pool declines from 993,351 at 6% CPR to 980,091. As a result, the “Total FV” is lowered to $1,029,202, reducing the break-even drop to 4+/32s.
Calculating MBS Carry
The calculation of carry for MBS is very similar to the dollar roll calculation, as the trader is attempting to determine the value of holding a pool over some alternative horizon period. A common reason for calculating carry is to price pool trades that settle after good-day within a particular month. Keep in mind that specified pools typically trade to some spread over (or behind) TBAs, and that after the monthly notification date TBA contracts for that month’s settlement no longer trade. As a result, trades to be executed later in the month must take the following month’s TBA price and adjust it for the earlier settlement date.
As an example, Display 5 shows the calculation of carry for the period between October 28th and November 14th (i.e., good-day settlement for November TBAs). After switching the toggle to “Irregular Settle,” the calculations indicate that the carry for the 17-day horizon period is worth 2.75 ticks. Therefore, traders should base their specified pool trades on a payup over the carry-adjusted TBA price, or 102-29+. Note that since the horizon period spans month-end, the holder accepts the revenue and costs associated with the P&I payment, and as a result the break-even is impacted by changes to the prepayment speed. (For intra-month calculations, the CPR is not a factor, since the trader is never the pool’s holder of record.)
Technical Factors and Roll Specials
As discussed previously, market drops often deviate from break-even roll values in either direction. Sometimes these pricing disparities reflect different prepayment expectations for a coupon and/or variations in the vintage expected to be delivered against open TBAs. For example, if a trader expects that buyers will be delivered a different (and better) vintage than the market’s assumed “cheapest-to-delivery,” their calculation of break-evens will be higher than the market drop, reflecting the expected slower prepayment speed (on premium coupons, of course).
Roll specials, by contrast, often result from technical conditions affecting both the front and back month TBAs. For example, CMO trading desks often need to buy pools as “collateral” for their deals, which typically settle at month-end. As a result, they often buy rolls in the coupons for which they’ve priced deals but haven’t yet purchased all the collateral; this duration-neutral trade nonetheless acts to increase roll drops. The Federal Reserve’s purchases also put upward pressure on front-month TBAs for the coupons in which they’re active; since they look to take delivery of pools, their purchases are primarily affected in front-month TBAs. At this writing, for example, roughly three-quarters of the Fed’s recent purchases have been in 30-year 3s, and the chronic specialness of the 3% roll for all products is often attributed to Fed activity.
Alternatively, trading by lenders also can impact the roll markets. For example, a surge in application and rate lock activity will tend to increase monthly drops. Since many locks are taken for terms longer than thirty days, originators will hedge their pipelines by selling back-month TBAs, and the selling pressure in the later months tends to push out roll levels, all things equal. Rolls also tend to become special around notification days if lenders’ pipelines are backed up and fundings are proceeding more slowly than expected. As a shortfall in closed loans becomes apparent, secondary desks will buy rolls to pair out of their existing front-month TBA sales, extending their hedges in time but putting upward pressure on roll prices.