The link between mortgages and bonds stems from the competition from investments. Both bonds and mortgage-backed securities are appealing to similar types of investors, typically those looking for stable returns with some degree of safety. Generally, as bond loan interest rates move, so do mortgage rates, albeit at a slightly higher level to reflect the added risk in mortgage lending. As mentioned earlier, bonds from November 2023 to April 2024 have a composite rate of 5.27%. Bonds issued from May 2023 to October 2023 had a rate of 4.86%.
Mortgage rates, of course, also increased along with the bonds, but at a somewhat higher level. For example, in May 2023, the rate for a 30-year fixed-rate mortgage was 7.17%, while in November 2023 it was 7.22%.
Remember, even though the current bond coupon rate is fixed, the bond price can fluctuate based on market sentiments and economic environments.
Impact Of Increased Bond Rates
To better illustrate this relationship, let's take a closer look. Let’s say that you buy a Treasury bond for $1,000 with a 2% annual fixed interest rate. Once you buy that bond, you’re locked into a 2% interest rate until the bond matures. Now, imagine that it’s a year later and interest rates are higher. The same $1,000 bond investment can net you a 3% annual interest rate.
The same year, you need some cash, so you decide to sell your bond. You probably won’t be able to sell your bond for the full $1,000. Other investors know that they can get 3% if they invest their $1,000 by buying a bond from the Treasury. The price of your bond will fall to whatever other investors are willing to pay for it.
For example, an investor might offer you $900 in cash for your bond. In effect, the price of your bond is lower now because current market rates are higher. Though you can still cash out your bond for $1,000 when it matures, its current liquid value is less than $1,000.
Impact Of Lowered Bond Rates
If the Treasury lowers bond rates, the opposite scenario will play out. Imagine the Treasury announces that $1,000 bonds will now have 1% interest rates. Investors know that they’re better off buying your bond than bonds from the Treasury because your bond accrues more interest. With more competition for your bond, you can sell to the highest bidder.
The bond you bought for $1,000 might now be worth $1,100 to an investor who wants to hold onto it until it matures. The investor who buys your bond for $1,100 will still receive $1,000 when he sells it. However, right now, it’s worth $1,100 because interest is on the decline and an investor wants to secure his money at a higher rate.
The Ripple Effect Of Bonds On Mortgage Rates
The ripple effect of these shifts is felt in mortgage rates. Mortgage lenders set their rates slightly above bond yields to attract risk-averse real estate investors while offering them a safeguard through property collateral.
This means when bond rates go up due to dropping prices, mortgage rates generally grow to match the trend. On the other hand, strong bond markets with high prices and low yields lead to reduced mortgage rates.
