Aston Lau

Why bond yields are closely linked to fixed mortgage rates

I must profess, I’m no expert on bonds. I’ve known for a while that bond yields are closely correlated to fixed rates, but I only recently figured out why this was the case.

First, if you’re not familiar with bonds, check out this excellent explanation of what bonds are. For those of you too lazy to click on the link, basically bonds are like loans: when the Government of Canada “issues you a bond,” you’re loaning money to the government to finance their operations. In return, they agree to pay you interest on the loan you’ve given them.

Technically, a bond is considered a “debt security”, which simply means the government is indebted to you.

The government isn’t the only entity that can issue bonds; companies can do it, too, in order to raise money for whatever it is they need to do.

Mortgage lenders (banks as well as private lenders) work this way — they raise capital by selling bonds. They find investors who have piles of money, issue bonds to those investors, and pay those investors interest. Now the mortgage lender has an even bigger pile of money; they turn around and use it to offer loans to us poor homeowners. And that, in a nutshell, is why bond yields are closely linked to fixed mortgage rates.

As I write this, the GoC benchmark 5-year bond yield has shot up to 2.88 from 2.50-2.64 just last week, meaning private institutions were also forced to offer their investors that much more for their capital. (Government of Canada bonds are considered practically risk-free, since they’re backed by the government; bonds from private institutions are not risk-free, hence investors demand higher interest for lending them money.)

Mortgage lenders wasted no time in passing on that added cost to homeowners, raising their fixed rates. Currently, the Big 5 banks’ 5-year “special offer” rates are at 4.54% or above.