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October 17th, 2008

Reader: Explain “A Bond’s Influence on Interest Rates”

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A reader wrote in with some questions regarding how the issuing and supply of new bonds affects interest rates. HSH Vice President Keith Gumbinger provided a simplistic breakdown:

It’s a matter of supply and demand. When an item is in short supply, the price of that item rises; when plentiful, the price falls.

In the case of bonds, a lack of supply causes prices to rise. An increase in price means that the ultimate return to the investor is lessened, so his yield is lower. Lower yields means lower mortgage rates.

Think of it like this (and quite simplistically).

A $1,000 one-year bond is for sale. It has a 5% yield. After one year, the return to the investor will be his $1,000 PLUS $50 in interest. His yield is 5%.

Two bidders show up for that bond (demand exceed supply, since there’s only one bond available). One buyers offers to pay only the full price — $1,000 for a $1,000 bond. The second offers to pay $1,010 for that $1,000 bond, or $10 over the face amount. The seller of the bond can make a $10 profit on the sale (or actually, only has to borrow $990 since hes got $10 free and clear), so he selects the second buyer. The bond yields 5%, but since the second buyer has paid an additional $10 to buy the bond, the second buyer’s actual return is only $40 ($10 comes out of the anticipated $50 in interest). Therefore, his actual yield isn’t 5%, but only 4% ($40).

This assumes the bond being offered is valuable and investors desire it, and there are more bidders than bonds. The reverse is also true.

If the seller has lots and lots of bonds, but there are few interested investors (lots of supply, little or finite demand) the seller may have to offer the bonds at a discount — selling a $1,000 bond for just $990, perhaps. The discount serves to attract buyers — the bond still has a base yield of 5%, but for $990, the buyer will get a full $1,000 back after a year, PLUS the $50 in interest. This improves the return (yield) to the investors — in this case, this buyer has an actual return of $60, or 6%.

So, an excess of supply which meets declining (or even finite) demand means there will be more bonds available than buyers. The prices of the bonds will decline to help attract them, which makes the yields higher. In this case, these are yields on Treasury Bonds, which have an influence on fixed mortgage rates; hundreds of billions of dollars of new bond issuance will be coming to pay for the various “bailout”, “rescue” or “support” programs.

This is also the case with mortgage bonds — too many sellers and too few buyers in the market these days — keeping prices low and yields (and mortgage rates) high.

Rates probably won’t decline very quickly, but there’s little reason for them to keep rising at the moment.

Be sure to read our article “What Moves Mortgage Rates” for more information.

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2 Responses to “Reader: Explain “A Bond’s Influence on Interest Rates””

  1. Kevin Says: October 17th, 2008 at 4:53 pm

    Thanks for this information about interest rates. It was very valuable information.

  2. Tim Manni Says: October 20th, 2008 at 12:43 pm

    Kevin,

    Thanks for reading and commenting, glad we could help. Hope to hear from you again soon, take care,

    Tim

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About the HSH Blog

HSH.com's daily blog focuses on the latest developments in the mortgage and housing markets. Our mission is to relate how changes in mortgage rates and housing policy, as well as the latest financial news, impacts consumers, homebuyers and industry insiders alike. Our 30-plus years of experience in the mortgage industry gives us an edge as we break down the latest changes in an ever-changing market.

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Tim Manni

Tim Manni is the Managing Editor of HSH.com and the author of their daily blog, which concentrates on the latest developments in the mortgage and housing markets.

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