How bond yields influence mortgage rates
When discussing the mortgage market, you’ll often hear interest rates brought up alongside bond yields, especially in relation to fixed mortgage interest rates.
In our monthly mortgage report, Perch Head of Mortgage Advisory Ali Hussin tracks 5 year bond yields to see where fixed interest rates are likely to go in the future.
So how do bond yields impact the mortgage market?
What are bonds?
First of all, let’s recall what bonds are.
A bond is an investment vehicle you can buy into in exchange for a return on your cash. Think of a bond like a loan that you give to a company or the government. In exchange for lending your money for a set period of time, the bond issuer promises to pay you back the money, plus interest. When we talk about bond yields in the mortgage space, we are usually referring to Government of Canada 5 year Bond Yields which closely follow and attempt to predict how the Bank of Canada will set their policy interest rate.
What determines bond yields?
The Government of Canada 5 year Bond Yield is set when the government issues its bonds. Generally bond yields follow the policy interest rate of the Bank of Canada who set the lowest cost of borrowing money for organizations like banks. When the market and bond traders believe that the Central Bank of Canada will increase rates, the Bond Yield increases and vice versa. In other words, the Bond yield is priced in anticipation of where the Central Bank of Canada rates will move. The Central Bank of Canada makes its rate decisions, based on the status of the economy. In this way, bonds are another economic indicator that analysts look at when trying to predict the market.
How are bond yields related to mortgage rates?
Bonds and mortgages are both types of loans that have set terms, but they work a little differently. When you buy a bond, you're essentially loaning money to a company or government, and they agree to pay you back with interest after a certain amount of time. Banks like to buy bonds because they know exactly how much money they'll make from the interest, and it's a pretty safe investment.
Mortgages, on the other hand, are loans that people take out to buy a house. Banks make money on mortgages by charging interest, but they're a riskier investment than bonds because there's a higher chance that the borrower won't be able to pay back the loan. Because of this extra risk, banks charge more interest on mortgages than they do on bonds.
When bond yields go up, it becomes less attractive for banks to invest in mortgages. They have to raise their rates to make up for the extra risk they're taking on, which means that mortgage rates also go up. So, when bond yields rise, it's generally a more expensive time to get a mortgage.
Bond yields have the most significant impact on fixed-rate mortgages. Mortgage lenders typically peg their fixed interest rates to bond rates, so when bond yields rise, fixed mortgage rates tend to follow. This is because banks use bond yields as a benchmark to determine their borrowing costs, and they pass on any increases in these costs to borrowers in the form of higher interest rates.
Conversely, when bond yields decline, fixed mortgage rates also come down. This is a direct relationship, as low yields on government bonds mean low rates on fixed-rate mortgages and vice versa. However, variable mortgage rates are not affected in the same way. Variable rates are tied to the prime rate, which is influenced by monetary policy decisions made by central bankers.
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