How Bond Yields Relate To Fixed Mortgage Rates?
Banks buy bonds as a low-maintenance (less costly) source of fixed-interest income. On the other hand, the fixed mortgage rates banks offer clients are a higher-maintenance (more costly) source of income since it costs more to operate mortgage loans.
Simply put, because fixed mortgage rates compete on similar terms with bonds to attract capital (e.g. 2-year, 5-year, etc.), banks look at the yield of those less-costly bonds to help determine how high or low to set rates of more-costly mortgages.
What Are Bonds & Bond Yields?
It is important to understand how prices, rates and yields affect one another when investing in bonds. A bond creates value over its lifetime, until it matures. A bond yield is the expected 'rate of return' during a bond's term length. In other words, how much value the bond creates?
One way which the government is borrowing money from the buyer is through a government bond. Upon bond maturity, the government is then responsible for repaying the face value of the bond. Since the bonds enable the government to pay off its debt and pay for its operations, the government benefits from this arrangement. Banks buy government bonds at a set price for a set term (e.g. 5-year) for a set interest rate.
It is worth noting that due to the current economic environment and market conditions, bond prices on the secondary market can be higher or lower than the face value of the bond.
Bond Price & Interest Rates
The price investors are willing to pay for a bond can be significantly affected by prevailing interest rates so that if prevailing interest rates are higher than when the existing bonds were issued, the prices on those existing bonds will generally fall. Conversely, investors can sometimes sell a bond for more than the purchase price if interest rates decline.
In general, there is an opposite relation between a bond price and a bond yield.
"Let’s say you buy a $20,000 corporate bond with a coupon rate of 5%. While you own the bond, the prevailing interest rate rises to 7% and then falls to 3%.
1. When the prevailing interest rate is the same as the bond’s coupon rate, the price of the bond is 100, meaning that buyers are willing to pay you the full $20,000 for your bond.
2. Prevailing interest rates rise to 7%. Buyers can get around 7% on new bonds, so they’ll only be willing to buy your bond at a discount. In this example, the price drops to 91, meaning they are willing to pay you $18,200 ($20,000 x .91).
3. The prevailing interest rate drops to 3%. Buyers can only get 3% on new bonds, so they are willing to pay extra for your bond, because it pays higher interest. In this example, the price rises to 104, meaning they are willing to pay you $20,800 (20,000 x 1.04)."
How to Calculate a Bond Yield?
Two parameters that are required to describe fully the cash flows on a bond are "the maturity date of the bond" and "the coupon rate".
The maturity date of the bond: When the principal, or face amount of the bond is paid and the bond retired
The coupon rate: the annual interest rate established when the bond is issued. Whereas a bond's coupon rate is fixed, the price of a bond sold in secondary markets can fluctuate.
There are several different approaches with its pros/cons to measure the bond yield earned by bondholders. Here is one simple method to do so:
Bond yield = Annual coupon payment (original interest) divided by bond price.
An original 5-year bond price of $2,000 comes with an annual coupon of $50 (provides 5.0% interest each year until maturity).
If sold for a higher price of $2,100, its bond yield lowers to $50/2,100 = 2.38%.
If sold for a lower price of $1,900, its bond yield increases to $50/1,900= 2.63%.
High bond yield & the risk
Higher yields reflect greater risk for bonds. If you look for safer investments, a lower yield may actually be preferable.
When interest rates are on the rise like our current market in June 2023, bond prices generally fall. When interest rates are lower, bond prices tend to rise. Bond price and bond yield are often inversely related.