Last time, we began a two-part series examining how bonds can have an impact on mortgage interest rates and mortgage-backed securities. If you missed it, you can find it here. Today, we are going to conclude the series with a closer look at how Treasury bonds in particular influence mortgage interest rates.
How Treasury Bonds Affect Mortgage Interest Rates
Treasury bonds are perceived to be one of the safest investment options available. All Treasury bonds are backed by the federal government, making them a safe bet in most cases. Many people consider Treasury bonds to be virtually risk-free, but this characterization isn’t quite accurate. There is still some risk involved, but because it is far less of a risk than other types of investments, it’s understandable why that perception continues to be perpetuated. The idea that Treasury bonds are low-risk make them a worthwhile investment in several cases, and their relative stability allows other institutions to depend on them. Banks, in particular, rely on Treasury bonds to determine interest rates on mortgages.
Bond Yield & Price
To understand how banks mirror Treasury bonds, it’s first necessary to understand how the face value and rates for Treasury bonds are set. Generally speaking, Treasury bond rates are determined by their yield. The yield is the total amount of money that a company or organization can earn by owning a Treasury bond.
How Yield Works
The yield of Treasury bonds is determined by supply and demand. The U.S. government sells these bonds at auction and sets the face value price and the interest rate beforehand. In times of economic crisis, or even stagnation, the demand for these bonds increases (because they are “safe” investments). This means that bonds at auction will sell well over their face value price. The higher the price at auction, the lower the yield will be, as the government is only responsible for paying the face value and the interest established prior to sale. The inverse is also true; when the demand for Treasury bonds is low, they will sell at auction under their face value price which means the buyer will receive higher yield returns. Yield prices tend to change regularly due to the fact that they are not usually kept for the full term, but are instead sold on the secondary market.
How Yield Affects the Economy and Mortgage Interest Rates
As previously mentioned, banks tend to reflect the interest rates of Treasury bonds, keeping them only a few points higher. The yield on bonds directly influences interest rates. When yield is high, interest rates also rise. Banks and other lenders also raise their interest rates to stay competitive in the market. Investors are more likely to invest if the return on their investment is worthwhile; that’s what higher interest rates encourage. Yield increase on the secondary market also forces the federal government to raise the interest rate on future bonds to attract future investors; higher rates then increases demand which should, theoretically, reduce the yield and allow interest rates to fall once again. At it’s core, the dance between yield and interest rates is designed to keep the entire system in balance.
How Treasury Bonds Affect Mortgage-Backed Securities
The relationship between Treasury bonds and MBS is also determined by yield and the interest rates on said bonds. Lower interest rates on Treasury bonds benefits the MBS market in two ways. First, low interest rates on bonds increases the principal value on MBS. Secondly, lower interest rates means that more borrowers will be able to prepay more on their mortgage, meaning that MBS are backed by more money upfront. The inverse is true here as well. When interest rates rise, MBS diminish in principal value, and the number of people who are able to prepay decreases significantly, extending the life of the loan.
Is it Possible to Predict the Future?
For skilled and savvy individuals, it is possible to develop estimations about the future of bond yields and market interest rates. Many defer to the “yield curve” when looking to the future. The yield curve refers to the “yields of U.S. Treasury bills, notes and bonds in sequential order from shortest maturity to longest maturity” (Bond Yield Curve Holds Predictive Powers). There are a number of factors that can determine the yield, supply and demand, as well as other factors contributing to the mortgage interest rate. Trying to navigate the path alone can be a tiresome endeavor. If you are an investor, loan originator, or any of the numerable professionals looking to navigate this road, you need an ally on your side.
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