At just over $7 trillion in size, the agency residential mortgage market in the U.S. is one of the largest, most liquid fixed income markets in the world. As with any large and sophisticated market, there are details and nuances unique to that market. Consequently, there are opportunities that experienced investors, steeped in the intricacies of such markets, can exploit to generate returns, reduce costs, or realize efficiencies. In the agency mortgage market, the use of TBA (To Be Announced) mortgage contracts is one opportunity that affords investors potentially all three of those benefits.

The most straightforward way to buy Agency RMBS exposure is to buy a specified pool of mortgage loans – each has a unique CUSIP, is backed by a fixed set of individual mortgage loans, and is bought and sold like any other bond, i.e., you pay cash for a certain par amount of the bond and then receive regular principal and interest payments from the underlying mortgage loans until they are all paid off. As one might imagine, there are hundreds of thousands of specified mortgage pools outstanding and each one is at least slightly different. A particular CUSIP may not trade for months or years, even if others very similar to it trade every day.

With TBAs, a market was created to facilitate trading in Agency RMBS, avoiding many of their complexities. The TBA market is also widely used by originators of mortgage loans to hedge exposure to loan originations where the fixed rate is locked in for the borrower early in the process, but the mortgage has not yet closed and the loan is waiting to be pooled into an Agency MBS. At the simplest level, it is a forward market similar in some ways to the Treasury futures market. As a forward market, at the initiation of a TBA contract, the exposure to the market is gained, but no cash is exchanged. However, at a specified settlement date in the future (typically within the next month or two) the investor must either close the position or pay cash for delivery of securities, very similar to a Treasury future, though in this case, the securities are agency mortgage pools.

This piece will explore the basic market structure and trading mechanics of TBAs as well as reasons investors choose to use TBA contracts instead of purchasing specified mortgage pools. It is not intended to capture all of the details of the TBA market or to be an exhaustive list of the factors that influence trading, rather it is intended to provide an overview of the market and an introduction to the calculations behind it.

TBA Trade Mechanics

There is a separate TBA for each coupon/issuer/maturity/settlement combination, such that TBAs exist for each coupon (2.0%, 2.5%, 3.0%, etc.) from both GNMA and UMBS (FNMA/FHLMC), for 15 and 30 year maturities, with each combination offering a settlement date once per month. For the below example, we’ll focus on a UMBS 2.0% 30 year in January, 2021, looking forward to the February, 2021 contract.

UMBS 2.0% 30 Year for February, 2021 Settlement Purchased in January, 2021

UMBS 2.0% 30 Year on the February, 2021 Settlement Date

Just before settlement date, the investor has 2 options:

1. The investor must take delivery of pools on the settlement date if the contract has not been closed out.
   • The investor receives an amount of mortgage pools that satisfy the delivery criteria (coupon, maturity, agency, etc.) but the specific pools and the number of pools that are delivered are at the discretion of the seller of the TBA.
   • The investor pays in full for the mortgages received at the price originally contracted plus accrued interest and the contract is closed.
   • When the Fed buys mortgages as part of their quantitative programs, this is how they do it – buying TBAs and then taking delivery.
   • TCW typically does not take delivery of TBAs, preferring to pick specific collateral characteristics that we find attractive to enhance relative value. However, in cases where the collateral pool is small, or we can otherwise ensure bonds with good characteristics are delivered, there have been instances where it has been attractive.
2. The investor can close the February, 2021 contract before settlement and simultaneously open the same contract, but for the March, 2021 settlement. This is referred to as “rolling contracts” or the “dollar roll,” and maintains the economic exposure of the position, though cash does change hands at the close of the contract as detailed below (under the simplifying assumption that markets haven’t changed and prices haven’t moved since January).

The gain of $1,875, which represents the current market price less the forward price locked in at the inception of the trade is the carry on the TBA. If market prices had risen for some reason (rates fell, mortgage spreads tightened, volatility dropped, etc.) the gain would be larger. If however, prices overall fell for the opposite reasons, the investor would be required to pay cash to the counterparty for the difference. Due to the specialness of the TBA, even though the TBA declined in price, the investor still benefited versus owning a similar pool, which would have fallen in price even more.

TBA Flowchart

The transaction described above is illustrated in the following flowchart, with the TBA trade down the right side in blue. To make the comparison clear, we also added a more traditional transaction of simply buying a similar mortgage pool for cash down the left side in green. If instead of buying the pool for cash, an investor borrowed money to buy the pool we can simply add the financing component in the middle in orange to make the combination comparable to buying and rolling a TBA. Borrowing money to buy a pool is virtually identical to buying and rolling a TBA, and in a perfectly efficient, arbitrage free world where TBA specialness did not exist, the profit from the pool after subtracting the financing cost would exactly match the profit from buying the TBA. Of course, in our sample transaction, TBAs do trade special, and so an investor earns a greater profit by buying the TBA rather than simply buying the pool.

*In the interest of clarity, we have ignored accrued interest in the pool example, which has no material impact on the analysis.

The Pros and Cons of TBAs

Pros: There are a variety of reasons why investors choose to use the TBA market rather than purchasing pools:

• Liquidity – The TBA market is highly liquid with many buyers and sellers in every environment. It functioned smoothly through the entirety of the Great Financial Crisis and subsequent periodic bouts of volatility, including the market lock-up that occurred across many markets in March of 2020 as a result of the COVID-19 lockdowns.
• Low Cost – Trading costs in the TBA market are small, with bid offer spreads for popular contracts generally quoted around 1 tick (1/32nd of a point, or 3.125 cents per $100 par), but can often be executed at even smaller spreads on the most active contracts.
• High Volume – TBAs are traded by many investors every day with typical average daily volume often in excess of $100 billion.
• Efficiency – Because no cash is required to enter into positions, TBAs are an efficient way to hedge, to adjust portfolio positioning, or to add exposure without disrupting other parts of a portfolio.
• Potential for Excess Return – Instead of buying a specified mortgage pool for cash, an investor might choose to purchase a TBA and invest the cash in higher yielding cash substitutes, potentially earning a higher return on what is economically a very similar investment.
• Positive Carry – At times, when demand for mortgages is high (and hence the supply of pools might be relatively low) brokers may make it more attractive for investors to roll their TBA exposure to the next month’s contract rather than take delivery, providing a “positive carry” or yield advantage versus specified pools. This is the TBA roll specialness illustrated above.

Cons: There are however, other reasons why investors may prefer holding specified pools over TBAs:

• Turnover – TBAs are generally monthly contracts, meaning to simply maintain exposure, an investor must open and close contracts every month, such that a portfolio consisting purely of TBAs would generate 1200% turnover every year, even if the risk profile never changes at all.
• Generic Exposure – TBAs provide no ability to choose specific collateral characteristics that might be desirable within a particular maturity and coupon band, so certain investors may prefer to choose specific pools with particular characteristics (geography, loan balance, etc.) that they believe will outperform.
• Adverse Selection – If an investor takes delivery of specified pools when the TBA settles, the broker chooses which pools that meet the basic criteria get delivered. Just like a futures contract, the broker will deliver the pools that allow them to meet their obligation at the lowest cost, so investors tend to receive the least expensive pools which also have the least desirable investment characteristics.
• Tax Inefficiency – Each close of a TBA contract may generate short term capital gains or losses. While those may balance out over the course of a year, if rates move significantly, the position could generate sizable gains or losses creating a large tax bill or unwanted income statement volatility.
• Accounting Complexity – Although the market exposure of a TBA position isn’t meaningfully different than owning a pool with similar characteristics, the volume of trades and the accounting for those trades is far more intensive and can be an administrative burden some investors aren’t willing to bear.

Conclusion

Although complex, mortgage TBAs can be a valuable tool to enhance portfolio performance, generate excess returns, and more efficiently manage portfolios. The team at TCW has been an active investor in this sector for over 30 years and has developed expertise supported by sophisticated tools and analytical models to identify and extract value where and when it exists. Our hope is that this piece has provided some additional insight into the markets in which we participate and promoted confidence in the underlying markets themselves as robust, attractive opportunities.