If you've been following the news over the past year, you've seen headlines about soaring interest rates, subdued inflation, record-high bond yields, a possible recession, and how this will affect your mortgage. To make sense of it all, it helps to decipher some basic economic principles.
We know that interest rates affect mortgage rates, but the truth is a bit more nuanced. Fixed-rate mortgage rates are determined based on the Government of Canada's five-year Treasury yield, which in turn is influenced by U.S. Treasury bonds. Adjustable-rate mortgages are influenced by the Bank of Canada's monetary policy – rising and falling interest rates – which affect the prime lending rates of commercial banks.
To better understand how mortgage rates fluctuate and where they may be headed, it helps to explain the difference between bond yields and monetary policy in a bit more detail.
How government bond yields affect fixed mortgage rates
A bond is a fixed-interest security in which a purchaser lends a fixed amount of money to the issuer for a fixed period of time. Bonds guarantee a fixed interest income (coupon rate) until maturity, which may be one, five, ten, or twenty years. When interest rates are relatively low, bonds have low coupon rates; when interest rates rise, coupon rates increase. When a bond matures, investors are repaid their original investment at face value (or par value).
There are many types of bonds, including government bonds (federal, state, and local) and corporate bonds.
A bond's yield is expressed as a percentage and is different from its coupon or price. Simply put, the yield is the income you will earn if you hold the bond to maturity.
The basic way to calculate current yield is to divide the coupon income by the bond's current price.
So if you buy a five-year bond with a 5% coupon for $1,000 (face value) and hold it to maturity, your yield will be:
Coupon amount = $50/year
Price = Face value $1,000
Yield = 5% ($50 / $1,000)
Note: Five-year bonds currently trade at a coupon rate of 3.25%, so this calculation is for illustrative purposes only.
However, once a bond is issued, it can be bought and sold in the secondary market, where the price is expressed as a percentage of its face value – i.e. a bond with a market price of 97 will be priced at 97% of its face value – so it is more accurate to express it as the yield that a bond returns on its market price.
Broadly speaking, when interest rates fall, older bonds with higher coupon rates become more attractive due to the potential income they can earn over their remaining life, and so command a “premium” in the market. When interest rates rise (to offset inflationary pressures, for example), the opposite is true – older bonds become less valuable and trade at a discount (other factors also affect bond prices, such as credit rating, time to maturity, and liquidity).
Using the example of a discount bond ($970) or a premium bond ($1,020), here is how the yield would change (note that the coupon or income generated by the bond does not change):
Scenario 1: Trading at a discount:
Coupon amount = $50
Price = $970
Yield = 5.15% ($50 / $970)
Scenario 2: Trading at Premium:
Coupon amount = $50
Price = $1,020
Yield = 4.9% ($50 / $1,020)
It's important to note that the bond market is complex, and this is an oversimplified definition of yield. Bond investors use the yield to maturity (YTM) calculation, which estimates the annual rate of return assuming the bond is held to maturity, interest payments are made on time, and the bond is reinvested at its original yield. (YTM is an annualized rate that allows bonds with different maturities and coupon rates to be compared.)
It's important to remember that bond prices and bond yields are inversely related: when demand is strong and bond prices are high, yields are low and access to credit is cheap. Conversely, when demand is weak and bond prices are low, bond yields are high. Also, bond prices (and yields) are constantly changing depending on market conditions.