How Bonds Affect Mortgage Interest Rates

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Bonds affect mortgage interest rates because they compete for the same type of investors. They are both attractive to investors who want a fixed and stable return in exchange for low risk.

There are three reasons bonds are low risk. First, they’re loans to large organizations, such as cities, companies, and countries. They are more likely to pay back the loans than individuals. 

Second, investors have good reason to believe a specific bond is low risk.

That’s because bond rating agencies study each company and bond. They report on the safety of these products. 

Third, bonds can be resold on a public market. They’re securities that are easy to trade. An investor doesn't have to keep the bond through the life of the loan.

Bond investors are looking for predictable outcomes, but some are willing to take on higher risk to get a better return. That's why there are various types of bonds. Investors constantly compare the risk of bonds versus reward offered by interest rates. The highest-risk bonds, like junk bonds and emerging market bonds, also have the highest return. Bonds with medium risk and return include most corporate bonds. The safest bonds include most municipal bonds and U.S. government Treasury notes.

All these bonds compete with mortgages for investors. But Treasurys have the biggest impact on mortgage interest rates. If Treasury rates are too low, other bonds look like better investments.

If Treasury rates rise, other bonds must also increase their rates to attract investors.   

Treasury Bonds Affect Mortgage Rates More Than Any Other Bond

Mortgages are higher risk than most bonds. The main reason is that they are longer-term either 15 years or 30 years. The most popular bonds that also have long terms are U.S. Treasurys.

They are offered at 10-year, 20-year, and 30-year terms. Banks keep interest rates on mortgages only a few points higher than Treasury notes. Since Treasury notes are guaranteed by the federal government, they are ultra-safe. As a result, investors don't require high rates. Many investors choose mortgages because they give a higher return than Treasurys.

As interest rates on U.S. Treasury notes rise, it means banks can raise the interest rates on new mortgages. Homebuyers will have to pay more each month for the same loan. It gives them less to spend on the price of the home. Usually, when interest rates rise, housing prices fall.

Treasurys Only Affect Fixed-Rate Mortgages

Treasury yields only affect fixed-rate mortgages. The 10-year note affects 15-year conventional loans while the 30-year bond affects 30-year loans. When Treasury rates rise, so do rates on these mortgages. Banks know they can raise rates once their primary competitor does.

The Federal Reserve affects short-term and adjustable rate mortgages. The Federal Reserve sets a target for the fed funds rate. It's the rate banks charge each other for overnight loans needed to maintain their reserve requirement. The fed funds rate affects Libor.

That's the rate banks charge each other for one, three and six-month loans. It also affects the prime rate. That's the rate banks charge their best customers. For these reasons, the fed funds rate affects adjustable-rate loans. These typically reset on a regular basis. 

Why Higher Treasury Rates Didn't Affect Housing in 2013

In 2012 and 2013, housing prices were rebounding from a 33 percent drop caused by the Great Recession. In many areas, prices doubled in just a year. That was the signal that many real estate investors sought. As prices rose, they once again felt that housing was a good investment. Many of these buyers used cash, which was sitting on the sidelines or invested in other commodities such as gold. These investors didn't care if interest rates rose because they didn't need mortgages.

Other homebuyers needed mortgages but knew that there was still plenty of room for housing prices to rise even more. They felt confident that real estate was still a sound investment, even if interest rates rose a bit. As home resale values increased, many homeowners who were upside down on their mortgages could finally sell that home and buy a new one.

Last but not least, as the economy continued to improve, many people returned to work for the first time in years. They'd been living with relatives or friends and could finally afford to move out and buy a home. So even though higher bond interest rates caused mortgage rates to rise, it didn't slow down the housing market. 

When Mortgage Rates Affected Treasurys

The 2008 financial crisis forced Treasury rates to a 200-year low. It was one of the few times that mortgage rates affected U.S. Treasury rates. Investor demand for mortgage-backed securities created the crisis. It ultimately led to the worst recession since the Great Depression.  Investors all over the world fled to ultra-safe Treasurys. Their demand allowed the U.S. government to lower interest rates on Treasurys.

What are mortgage-backed securities? They are securities that are backed by the mortgages that banks loan. Rather than hold them for 15 years to 30 years, the banks sell the mortgages to Fannie Mae and Freddie Mac. These two government-owned companies bundle them together and sell them on the secondary market. That's where hedge funds and large banks buy them as investments.

The financial crisis showed that many mortgage-backed securities were risky. They contained high and undisclosed levels of subprime mortgages. When home prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds and corporations who owned these derivatives. That created the financial crisis and recession.

In Depth: How Bonds Affect the Stock Market | How Bonds Impact the U.S. Economy