How Are Mortgage Rates Tied to Bond Markets?

Bond markets strongly influence the cost of the average mortgage.
i Photodisc/Photodisc/Getty Images

Monthly mortgage payments are often the biggest expense in a family budget. In today's global and often turbulent economy, mortgage rates vary constantly. In particular, changes in the bond market have a strong influence on mortgage rates, and therefore your monthly mortgage obligations. A better understanding of this relationship will help you make smarter financial decisions.

Mortgage-Backed Bonds

After a bank extends a mortgage, it often passes the right to collect your monthly payments to another institution in a process known as securitization. This process is key in understanding the relationship between bonds and mortgage rates. Similar mortgages are combined, and the bank passes the right to their monthly payment streams on to an investor in exchange for a lump sum. Here's how it works: Assume a bank lent money to 100 homeowners. The bank agrees to allow, say, a mutual fund to collect and keep these monthly payments, and the bank receives $20,000,000 in return, which it can lend to 100 new home buyers.

Bonds vs. Mortgages

The right to collect the monthly mortgage payments of homeowners is, financially, very similar to owning a bond. The mutual fund invests a lump sum up front to receive periodic payments. Differences between owning a bond issued by a corporation and the right to the payments of 100 homeowners are relatively minor. While a bond may pay the investor every three months, securitized mortgages pay every month. In addition, the bond makes a lump sum payment upon expiration, while homeowners merely make a regular final payment on the last month. However, securitized mortgages compete directly with bonds for investors' dollars.

Bonds Yield

Many entities, including the federal government, state governments, corporations and foreign nations, issue bonds. A bond's yield is the rate at which money invested in these bonds grows through interest payments, and when it's low, mortgage rates decline. When bond yields go up, mortgage rates increase. Yields on bonds issued by the federal government are particularly relevant; they carry no default risk since the government can print money to pay bondholders. To entice investors to invest in mortgages instead, which always carry risk, the expected payments have to be significantly higher. Therefore, increasing bond yields leads to higher mortgages for homeowners.

Indirect Effects

Higher bond yields mean companies pay higher interest expenses to borrow money. This results in less borrowing to finance investments in new products and projects. Therefore, in a high-yield environment, companies hire fewer workers and pay less to longtime employees, and the economy slows down. This increases the risk that homeowners will lose their jobs or face a wage cut and consequently default on their mortgage payments. In order to assume this higher risk of default, lenders ask for higher mortgage payments.

the nest