What is the “bond” in the “bond rate”?
Fixed-rate mortgages are based on the bond rate, and we have to understand what a “bond” is before we can fully break down that term.
When the Canadian Government needs to borrow money to conduct its various obligations and services, it issues government bonds. These are essentially promises by the Government that anyone who purchases these bonds will be paid back in full plus interest. Because they are issued by the Federal Government, these bonds are considered some of the safest investments available.
“The Government needs to offer investors a competitive return to encourage them to lend their money,” says Hebdon. “So that return is influenced by things like inflation expectations, economic conditions and what investors could earn elsewhere.”
The most notable bond for fixed-rate mortgages are the five-year bond yields. That is, bonds to be paid back in five years. Sounds good, but what is a “yield”?
Because no bank or investor wants to hold onto a bond that has a lower interest rate than other bonds out there, bonds are continually traded. These parties buy and sell bonds on the bond market and the difference between the original purchase price of a bond and its current selling price determines the yield. Each bond is also assigned a coupon, which is how much it pays out at the end of the year. That is, it’s the interest rate of the bond.
Here’s an example to help understand how it works:
- A bank buys a five-year bond for $2,000 with an annual coupon of $50 (a.k.a. an interest rate of 2.5% annually).
- The bank can decide to sell this bond in response to market conditions. Interest rates are always in flux so they want to ensure they’re getting the most out of it. For instance, higher interest rate bonds may be issued, and of course a bank would want those instead of its current batch of lower interest rate bonds. Two things can now happen:
- The bank sells its original $2,000 bond for more, say $2,100, to someone else. That bond’s yield is now ($50/$2,100) * 100% = 2.38%.
- The bank sells its original $2,000 bond for less, say $1,900, to someone else. That bond’s yield is now ($50/$1,900) * 100% = 2.63%.
When bond prices go down, yields go up, and vice-versa. The market is constantly changing, so these yields change as well. The overall yield rate is tracked by pegging the mid-point between the highs and lows over time.
How do these bond yields impact fixed-rate mortgages?
That’s bond yields explained (in a simplified fashion, there’s a lot more complexity to it all but this works for our needs). So, how do they affect fixed-rate mortgages?
Banks use bond yields to set the rates of fixed mortgages because mortgages are much more volatile than government bonds. The government is usually pretty reliable in paying back banks and lenders, but mortgage holders are less so in comparison (even though Canadians are quite skilled at juggling very high levels of home mortgage debt).
“If you compare [a bond] to a mortgage – even someone with excellent credit, strong income or is considered a very low risk borrower – there's still more risk involved in lending that person money than there is in lending to the Canadian Government,” says Hebdon. “So, because of that, lenders need to factor in what's called a spread, which is essentially the margin that reflects the additional risk – [the] funding costs and expenses associated with lending that money.”
Hebdon goes on to say that if investors can earn a competitive return from the Canadian Government, they need additional incentives to make the extra risk of taking on mortgage lending worth it. Bonds offer that incentive, and banks tie their fixed-rate mortgages to them. It’s also handy that bonds and fixed-rate mortgages have similar terms, like two-year and five-year terms.
“When the government bond yields increase, the cost of offering fixed rate mortgages generally increases as well,” says Hebdon. Remember, yields increase when banks sell a bond for less than they bought it for.
That could happen for many reasons. Inflationary pressures are one reason. Hebdon explains that as inflation increases, the Government may increase interest rates to curtail extra spending. But that means there could be new bonds entering the market that are more attractive because of their higher interest rates, and banks wouldn’t want to hold onto their older, lower-interest bonds. So they’ll sell them off, likely at a loss, and yields will go up, in turn pushing fixed mortgage rates up, too.
What do BoC rate announcements have to do with any of this?
To put it shortly, Bank of Canada rate announcements have little immediately to do with fixed-rate mortgages. BoC announcements impact variable-rate mortgages, which are directly pegged to the BoC’s rate. And while housing is one metric the BoC looks at, it’s not the only one.
“I think it's important to remember that the Bank of Canada isn't just looking at the housing market when making these decisions,” says Hebdon. “They're looking at employment, consumer spending and economic growth.”
These are all things that impact the bond-market too, but in a much more long-term and less direct way. But this also doesn’t mean you can’t use the BoC’s rate announcement to get the “vibes” of what could happen to the bond market and in turn your fixed-rate mortgage when it’s time for renewal.
For instance, if inflation is high and the BoC responds with a rate hike, bond holders may try and sell of their current crop of lower-rate bonds in anticipation of higher-rate bonds coming later, which means yields are likely to go up (because who would buy these old bonds at full price if they don’t have appealing coupons?).
So the BoC’s rate announcements are an indirect indicator of what bonds could do, and therefore what fixed-rate mortgages could do later.
Still, remember that’s a very complex task. As Hebdon explains, “While the bank makes its decisions based on what's happening in our own economy, it does also need to consider what's happening south of the border. We can't completely separate ourselves from the US economy for that reason.”
There are all sorts of things that could happen that the bond market may respond to, and BoC rates are just one of those things in the grand scheme of it all.
What should homeowners and buyers do about higher fixed-rate mortgages?
Now that you know how fixed-rate mortgages work, is there anything you can do about them getting more expensive?
“I think one of the most important things for buyers and existing homeowners to understand is that there are often more options available than they may realize,” says Hebdon. “It's not always about finding the lowest interest rate.”Hebdon explains that a fixed-rate mortgage may make sense even if it’s not the lowest-interest rate option available. For example, the steadiness of the rate itself could help make budgeting more predictable and remove the anxiety brought about by every possible BoC increase impacting variable-rate mortgages. It’s also possible to restructure and consolidate debts, to make payments simpler.
“There are ways to build in safeguards, such as choosing a variable mortgage with a static payment or increasing what that monthly payment would be as if it's based on a fixed rate,” Hebdon goes on to say. “But [you’re] still kind of watching the market and moving forward with a variable rate. I think the biggest takeaway is that higher rates don't necessarily mean fewer opportunities.”
In fact, for potential buyers, higher rates may come with an unexpected silver lining. While it is true that higher mortgage rates tend to make buyers anxious, if you’re in a stable position as a potential buyer and still able to afford a mortgage, whether fixed or variable, higher rates could mean less competition for you. And since sellers would be more willing to negotiate in a buyer’s market, you could find opportunities not available otherwise.
As Hebdon explains, “When activity slows like this, it can be a good opportunity for buyers to have more negotiating power and have more time to make informed decisions and better opportunities and find a home that actually works for them with less pressure.”
