How Savings Bonds Impact Mortgages

Ask most people what a mortgage is, and they will likely say that it is a loan used to buy a house. Ask what a savings bond is and you may get a few confused looks, but many will say something about how bonds are loans from the buyer to the Treasury, in return for interest. If you were to then ask how the two were related, blank stares would probably be the most popular reply.

To understand how bonds impact mortgages, it is necessary to know what happens with a mortgage after it closes. Mortgages are significant amounts of money, and lenders can’t keep making loans if all of their capital is tied up in existing loans. To free up money for future loans, lenders bundle groups of mortgages together into pools and sell bonds that are secured by the payments from the mortgages in the pool. These bonds are called mortgage backed securities (MBSs).

In the financial markets MBSs compete for investors’ dollars with other interest paying investments, like Treasury bonds. While ordinary MBSs are very secure, some credit risk is always present compared to a no-risk Treasury bond. Additionally, there is the risk of borrowers paying off their mortgage early. Since this usually happens when interest rates go down, the holder of the MBS would probably have to re-invest at a lower rate. Because of the additional risk, MBSs have to pay a higher yield than a comparable Treasury issue. In general, MBSs backed by 30 year mortgages tend to track 10 year T-Note rates, with a premium of about 2% higher yield than the T-notes.

Treasury securities are sold at auction, with the yield being determined through a competitive bidding process. A host of objective and subjective factors influence demand and result in higher or lower yields over time. To stay competitive, MBSs must pay higher rates when Treasury rates increase. Since the payments from an MBS are financed by the payments on the underlying mortgages, this means that mortgage rates have to rise to pay the increased yield. Alternately, if Treasury rates decrease the comparatively higher yield of MBSs is more attractive, which leads to increased demand and reduces the yield the MBS needs to pay to find buyers.

While a truly in-depth analysis of the interactions and complexities of Treasury bonds and mortgage rates would fill a book, I hope that this article helps to explain at least the basics.