Thursday, Aug. 20
Written 10:30 a.m. EDT
DOWN A LITTLE: The 30-year fixed fell 15 basis points in this week's Bankrate.com survey. Rates for other types of mortgages didn't fall as far.
BONDS AND RATES: This question comes from a reader named Janet: "How do bond values affect mortgage rates?"
For our purposes, let's confine our discussion of bonds to mortgage-backed securities, which behave like bonds. Also to keep it simple, we'll talk about conforming mortgage-backed securities, without tranches. When you buy such a mortgage-backed security, you're buying the right to receive principal and interest payments on an underlying pool of mortgages.
This bond -- this mortgage-backed security -- is an IOU. Owning this bond means that a bunch of people collectively owe you money via monthly mortgage payments.
Mortgage-backed securities are extraordinarily complex because they carry various types of hard-to-measure risks, and those risks affect one another. There's the risk of nonpayment, of course, but also the risk that borrowers will pay off their loans earlier than expected in a refinancing boom, and the risk that they'll keep their loans longer than expected if rates go up and stay there.
So let's step back and discuss the simplest type of bond. Same concept as a mortgage-backed security, but much less complex. This simple bond is a one-year IOU. You lend someone $100, and the borrower pledges to repay you 50 cents a month in interest for the next year, and the principal amount of $100 a year from now. That IOU is a one-year bond with a yield of 6 percent.
The day you lend the money, you could immediately sell the IOU for $101. The buyer would pay $101 for the privilege of receiving $106 over the next year. The bond yield would be about 5 percent. As you see, the price of the bond went up, so the yield went down.
You also could hold the IOU for six months. After receiving $3 in monthly interest payments (remember, you've been getting 50 cents a month), you decide to sell the bond. Maybe you think the borrower might lose his or her job, so you're willing to unload it for $99. That $99, plus the $3 in interest you received over half a year, means you earned a net $2 interest in half a year, for a yield of 4 percent. The buyer, on the other hand, hopes to receive $3 interest over the next six months, plus $100 at the end of the year -- thus making a $4 profit in six months on an investment of $99, for a yield of about 8 percent.
Hope that's a clear-as-mud explanation of how yields (and, therefore interest rates) go up when bond prices go down, and vice versa.