Mortgage Rates and the Bond Market

What moves Mortgage rates?

There are a seemingly large number of questions into what exactly moves mortgage rates. This is good because there are a seemingly large number of answers. It is a combination of various factors that include economy performance, inflation, banks, consumer activity and the capital market/bond market.

Mortgage Funds

To determine firstly how mortgage interest rates are decided it is good to see where mortgage money comes from. It comes from bank deposits, mutual fund/investments deposits but mostly from capital/bond markets. Capital markets are markets in which institution buy and sell long term financing. Most commonly capital markets trade in bonds. So this consequently results in bond rates and mortgage interest being tied together.

Bonds and Mortgage Rates

In an effort to get investors, bond-sellers will try and offer the best deals to get funding. This is done by offering debt instruments which have a variety of structures of risk, yields and time periods. Bonds will compete with other investments which are thought to perform the same such as treasury bills, foreign and private bonds among other debt instruments.

Bond Rate versus Mortgage Interest Rate

The bond market and mortgage rates are tied together because of private consumers like you and me. The market will generally want high investment/bond interest rates but low mortgage rates. Which are both contradictory to each other because one pays for the other

How are Mortgage Rates tied to Bonds?

So now we know that the public want contradictory things. So mortgage rates must then somehow balance with bond rates. If one goes up, the other has to as well. But the goal to meeting public demand is to always keep bond rates high and mortgage rates low.

This is where other investments play a factor. Private investors will be looking at other investments like the stock market, treasury bills and so on. If they offer more attractive yields then the bond issuers have to ensure they offer better returns on their bond in order to effectively compete with these other markets.

The only way for them to do this is to raise interest rates. So bonds and mortgage rates will forever be unequivocally linked as bonds fund mortgage capital and mortgages fund bond interests.

At the end it becomes a balance between which institution can give the highest rates of return for their bonds and which can give the lowest interest rates for mortgages. In order for the cycle to work both mortgage rates and bonds must work. Private investors however are the ones who decide how these rates are.

It is not as simple as that between bonds and mortgage rates however. Because bonds are long term instruments and its yield is fixed so the rates of existing bonds cannot be changed. Instead its face value is what changes. This means that its dollar amount is governed by how the market is performing. If its yield is low compared to current bonds mortgage rates, then its dollar value will drop because investors are better off buying newly issued bonds. It is vice-versa for the opposite.

http://library.hsh.com/read_article-hsh.asp?row_id=85
http://www.bloomberg.com/markets/rates/
http://www.mtg-net.com/sfaq/faq/whyrateschange.htm