How Do Bonds Affect Mortgage Rates?
Whenever you hear people trying to predict whether mortgage rates will go up or down in the future, you may hear them use bond prices as a reference. But how do bonds affect mortgage rates? Follow along below to see how the bond market inversely affects mortgage rates and what that means for you.
Understanding Bonds And Mortgage Rates
Bonds and mortgage rates have an inverse relationship, meaning that when bond prices decrease, mortgage rates increase. To understand this relationship, look at it through the eyes of an investor.
If you're looking to invest in the bond market, you may have to decide whether to invest in U.S. Treasury bonds or mortgage-backed securities (MBS). The U.S. Treasury Department determines the yield on Treasury bonds, while the yield on MBS is determined by the terms of the mix of mortgage premium and interest payments packaged into an MBS product.
Let's say you own a $1,000 Treasury bond with a 4% annual interest rate. A year later, you want to sell the bond on the secondary market, but the Treasury has since increased bond interest rates. Other investors can now invest the same $1,000 with the Treasury and get a 5% annual return, so there’s less competition for your bond. To compensate for this, you offer to sell your Treasury bond for $900, so you can get liquid funds quickly, and the investor who buys it has a larger yield over time.
Your decision to lower the price of your treasury bond also affects mortgage rates. Organizations selling MBS in the same secondary market want the investor that paid you $900 to buy their products instead. To do this, they need to offer higher interest rates to investors to make the MBS more attractive. So they raise interest rates on the mortgages they package together to give investors a higher return. They base these rates very close to, but slightly higher than, the interest rates on Treasury bonds because they are seen as a benchmark for interest rates. Mortgage rates are slightly higher to account for risk because mortgages are more likely to default on their payments than Treasury bonds.
How Do Bonds Work?
The most well-known type of bond is the U.S. Treasury bond. A treasury bond is essentially a loan to the U.S. government for which an investor receives a fixed interest payment. For example, let's say you buy a $1,000 treasury bond directly from the U.S. Treasury Department with a 5% annual fixed interest rate and a 10-year maturity timeline. That means the U.S. government will pay you $50 in interest every year and promise to give you back the $1,000 principal after 10 years. Since these loans are backed by the full faith and credit of the U.S. government, they’re viewed as essentially risk-free investments, but they also offer relatively low returns.
Corporations can also offer their own bonds on similar terms. You can loan money to a corporation that will pay you interest on the loan and repay the principal at maturity. The main difference between corporate bonds and Treasury bonds is the risk you assume since corporations are more likely than the government to be unable to repay investors. However, this heightened risk also comes with higher returns.
Mortgage-backed securities (MBS) are another type of investment product that competes with Treasury and corporate bonds in the secondary market. MBS are groups of mortgages packaged together and sold to investors who receive a portion of the principal and interest payments on the mortgages in the group. When a homebuyer signs a mortgage, the lender quickly sells it to a government-sponsored enterprise (GSE) like Fannie Mae or Freddie Mac, which packages hundreds or thousands of similar mortgages into one MBS package and sells it to investors.
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How Does The Bond Market Affect Mortgage Rates?
As mentioned above, the bond market and mortgage rates have an inverse relationship because mortgage lenders compete with Treasury bonds on the secondary market. As bond prices increase, mortgage rates decrease. And the reverse is true: As bond prices decrease, mortgage rates increase.
For another example, let's explore what happens when bond prices increase. Let's say you want to sell the same $1,000 Treasury bond with a 4% interest rate. However, you waited 2 years to sell it this time, and Treasury interest rates are now at 3%. Since your bond offers a larger return over time than current Treasury bonds, there will be more competition, so you could sell it for $1,100.
This higher price may be too high for some investors, so they will look for other options in the secondary market, such as MBS. They're priced out of your offer but still want better returns than what they can get directly from the Treasury. So they’ll be willing to accept lower interest rates on MBS products, incentivizing organizations like the GSEs and banks that buy and sell MBS to create packages with lower mortgage rates.
It's critical to note that not all mortgage rates are affected by the bond market. Bond prices only affect fixed-rate mortgages. Adjustable-rate mortgages (ARMs) are susceptible to decisions by the Federal Reserve (Fed). If you have an ARM, your monthly interest rate will depend on the short-term target for the federal funds rate set by the Federal Reserve.
The Bottom Line
So how do bonds affect mortgage rates? Bonds and mortgage rates have an inverse relationship, so when bond prices go down, mortgage rates go up. This inverse relationship exists because they compete for investor funds in the secondary market. If you’re looking to purchase a fixed-rate mortgage, it may be helpful to track changes to the bond market as well as mortgage rates. If you've done your research and are ready to buy a home, start the approval process today!