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Understanding Talk about Rate Changes and Bond

Bond yields have been mentioned in recent speculation about continued mortgage rate cuts. However, it’s not obvious to most people how bond yields relate to mortgage rates. This post is a straight forward explanation of the relation between the two.

What Are Bonds?

When a bank issues a mortgage, it finances the mortgage by issuing bonds. A bond is a lot like a Guaranteed Investment Certificate (GIC) account.

With a typical GIC:

  • you lend the bank a principal amount for a defined time (called *the term*); and
  • receive interest payments during that term.

When the term ends, you get your principal back.

Bonds work the same way. However, bonds can also be bought and sold, which means bond prices can rise and fall.

When that happens, the relative amount of interest earned on the amount paid for the bond when it is resold will differ from the relative amount of interest that was being earned on the bond when it was issued.

In context

For example, say the bank issues Joe a bond for a principal amount of $100 that pays 3% interest annually.

If Bonnie pays Joe more than $100 for that bond, she will earn less than 3% on her investment. In financial jargon, her yield will be lower than Joe’s yield.

Now, why would Bonnie pay more than $100 for Joe’s bond? If Joe bought his bond after the banks lowered the interest they pay on bonds, Joe’s bond would pay more interest than the banks offer, and some people might pay a premium for that.

Now, if you expect banks to pay less interest on bonds in the future, you might want to buy bonds, so you can sell them for a profit, like Joe did. When the number of bonds that people want to buy starts to overtake the number of bonds for sale, buyers will pay a premium for bonds in order to motivate sellers to sell their bonds to them.

As noted in the last paragraph, when people pay a premium for a bond their yield is lower. Accordingly, some commentators interpret falling yields as an indication that people expect that bonds will pay less interest in the future.

How do falling bond yields relate to mortgage rates?

The idea is this: Banks issue bonds when they issue mortgages.

If bond yields indicate that the market expects banks to pay less interest on those bonds in the future, and if the market is right, then the bank’s cost of issuing a mortgage will be lower. If lower borrowing costs to banks results in lower mortgage borrowing costs for their customers, then falling bond yields indicate that mortgage borrowing costs will be lower in the future.

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