Relationship of Bond to Mortgage Rates

by Tim Plaehn

Bond yields and mortgage interest rates are closely related. In fact, mortgage rates typically move in tandem with bond market interest rates.The reason for this is because mortgage loans are eventually sold to investors, and those investors have choices where to invest their money, including Treasury bonds and mortgage securities.

Mortgage Securitization

Mortgage rates end up closely tied to bond interest rates due to the securitization of mortgage loans. After a home loan is originated it will be packaged into a pool of mortgages with similar characteristics and the pool will be divided and sold to investors as a mortgage-backed security. Mortgage-backed securities compete in the bond markets for investor money, so the rate has to be high enough to attract investors. Mortgage lenders compete on yield, so lenders will keep rates as low as possible yet still make mortgages marketable. The result is uniform mortgage rates across the country.

Fannie and Freddie

Fannie Mae and Freddie Mac are government-sponsored companies that purchase a large portion of the mortgage loans originated in the U.S. and repackage those loans into mortgage-backed securities. With the implied government backing, the mortgage-backed securities issued by Fannie and Freddie have AAA credit ratings, putting them directly in competition with the debt securities issued by the U.S. Treasury. The result is mortgage rates that conform to the standards of Freddie Mae and Freddie Mac are influenced by the interest rates on Treasury bonds.

Treasury Note

The bond most closely associated with mortgage rates is the 10-year Treasury note. Mortgage securities have indefinite maturities. The securities pay off as homeowners make monthly payments and refinance or sell their homes. The actual maturity of a mortgage-backed security is typically seven to 10 years. The Treasury issues seven-year notes, but the 10-year note is the most widely followed of all of the Treasury security maturity rates.

Mortgage Treasury Spreads

Interest rate watchers keep an eye on the spread between mortgage-backed securities and the 10-year Treasury rate. Most of the time the rates move in parallel, rising or declining together. Historically, the spread between the two rates has averaged 1.5 to 2 percent. The spread can widen or narrow as each type of security has its own supply and demand dynamics. A prospective home buyer can watch changes in the 10-year Treasury rate and have an idea where mortgage rates are going.

About the Author

Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.

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