Bonds have different returns based on the risk to the investor. High risk bonds, like junk bonds and subprime mortgages, have the highest return. These are attractive to investors who are willing to take on the extra risk to receive a higher return. Bonds with medium risk and return include mortgages and corporate bonds. The safest bonds include most municipal bonds, and U.S. government Treasury notes.
Even though Treasury bonds have a lower return, they do affect mortgage interest rates. That's because investors who are in the market for mortgage-backed securities expect a higher interest rate on these higher risk securities than offered on Treasuries. What are mortgage-backed securities? They are backed by the mortgages that banks loan, but rather than hold them for 15 to 30 years, the banks sell the mortgages to Fannie Mae and Freddie Mac, who then sell them on the secondary market. They are bought by hedge funds and large banks, who sell the securities backed by these mortgages.
For this reason, banks generally keep interest rates on mortgages only a few points higher than Treasury notes. Since Treasury notes are guaranteed by the Federal government, they can afford to offer lower rates.
Therefore, lower interest rates on U.S. Treasury notes mean lower rates on mortgages. This allows homeowners to afford a larger home, and renters to afford their first home. This increased demand stimulates the real estate market, which stimulates the economy. Lower mortgage rates also allows homeowners to afford a second mortgage, which allows them to purchase more consumer products. This also stimulates the economy.
Bonds FAQ
- What Are Bonds?
- What Types of Bonds Are There?
- How Do Bonds Interact With the Stock Market?
- How Do Bonds Interact With the U.S. Economy?
- How Do Bonds Affect Mortgage Interest Rates?
