How Bonds Affect Mortgage Interest Rates

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

Why Bonds Are Low Risk

There are three reasons bonds are low-risk:

1. They’re loans to large organizations, such as cities, companies, and countries. These entities are more likely to pay back loans than individuals.
2. Bond rating agencies study each company and bond. They report on the safety of these products. This gives investors a good reason to believe a specific bond is a low risk.
3. Bonds can be resold on a public market. They’re securities that are easy to trade, so an investor doesn't have to keep the bond through the life of the loan.

Still, different types of bonds carry different risk levels. Bond investors are looking for predictable outcomes, but some are willing to take on a higher risk to get a better return. Investors constantly compare the risk of bonds versus the 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 Drive Mortgage Rates

Because they are longer-term bonds—usually 15 or 30 years—and dependent on individual repayment, mortgages have a higher risk than most bonds. U.S. Treasury notes offer similar term lengths—at 10, 20, and 30 years—but are ultra-safe due to their government backing. As a result, investors don't require high rates.

Banks keep interest rates on mortgages only a few points higher than Treasury notes. Those few points of higher return are enough to push many investors toward mortgages.

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 eventually 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 competitors do.

The Federal Reserve affects short-term and adjustable-rate mortgages. The Fed sets a target for the fed funds rate—the rate banks charge each other for overnight loans needed to maintain their reserve requirement. This, in turn, affects the following:

• The London Interbank Offered Rate (LIBOR): the rate banks charge each other for loans ranging from overnight to one year
• The prime rate: the rate banks charge their best customers

All of these influence adjustable-rate mortgages and other fluctuating-rate loans independently of Treasurys and other bonds. These rates typically reset regularly.

When Mortgage Rates Affected Treasurys

The 2008 financial crisis forced Treasury rates low. It was one of the few times that mortgage rates affected U.S. Treasury rates, rather than vice versa. The crisis began as investor demand for mortgage-backed securities rose. These securities 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, where hedge funds and large banks buy them as investments.

As investors went crazy for mortgage-backed securities, it ultimately led to the worst recession since the Great Depression. 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 that owned these derivatives. That created the financial crisis and recession.

Amid this downturn, investors all over the world fled to ultra-safe Treasurys. Their demand then allowed the U.S. government to lower interest rates on Treasurys.

Rising Rates in Recovery

In 2012 and 2013, housing prices were rebounding from a 33% drop caused by the Great Recession. Prices began to increase again. 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 was 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.

Bonds—and U.S. Treasury notes, in particular—have a close relationship with mortgage interest rates. Understanding what's happening in the bond market can give you a decent picture of what's coming on the mortgage front.