What Bond do Mortgage Rates Follow?

Why are bonds tied to Mortgage Rates?

The question into why bonds are tied to mortgage rates is something that has always echoed through investor’s and the public’s minds. The best way to understand this relationship is by following the money. The first question is; where does the funding for mortgages come from?

Mortgage money is funded through a few instruments including bank deposits and the capital market. The latter is however where the bulk of the money comes in from.

Capital markets are the where public and private institutions gain financing by buying and selling long-term securities. Institutions both take and contribute to the capital market. The capital market will typically consist of both the stock market and the bond market. The stock market allows institutions to both buy and sell shares in their companies among other things like futures and options. Listing a company on the public stock exchange is way of raising the capital of a company by attracting new money from public investors.

Banks and lending institutions however primarily use the bond market for funding mortgages. Mortgage bonds primarily can be traded on the market where the lending institution issue bonds that are backed by the properties they mortgage. The interest payment on the mortgage then becomes the yield for the bonds.

Hence in order to raise capital for mortgages it is vital that a bank become competitive in the bond market. High-yield bonds will attract investors more then low-yield bonds. In order to account for the high-yield bonds the lending institution must raise mortgage interest rates so that interest payments can pay for the higher payouts. This is how bonds and mortgage rates are linked

What Bond do Mortgage Rates Follow?

There are a lot of bonds in the market including government bonds, corporate bonds and mortgage bonds. In a sense mortgage rates follow all these bonds because to be competitive all bonds follow other bonds.
More specifically however mortgages follow mortgage bonds as this is where the lending institutions directly fund their mortgages from.

Other Factors

There are other factors in place besides bonds that decide mortgage rates. It however is not the Federal Bank as most of the public think. The federal bank only decides on borrowing rates between banks who want short term loans. These loans could last just a few days and are mostly used so banks meet their daily debt to equity ratios. Even then these rates are just not set in stone and a different rate can be negotiated between both the institutions.

It is not just the bond market that affects interest rates. Inflation too plays a part. For example if inflation is expected to be 3% for the year and interest rates are tagged at 7%, the actual return investors will be getting is only 4%. This adjusts for the time value of money which means that the value of money is always dropping due to rising costs (inflation). So if inflation is expected to lower or drop then this allows interest rates to drop in order to adjust with the economy.

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