How Does the Canadian Bond Yield Work and How Does It Affect Your Mortgage Rate?

2024-06-20 | 08:15:48

Did you know approximately 53% of Canadian's do not fully understand the terms outlined in their Mortgage? My goal is to provide you, the customer, a deeper understanding on how Mortgages work. There are many mortgagge products out there, and finding the right product to fit your financial profile and goals could be overwhelming. Before we get into all the products, terms, fees, and additional jargon lets start with the main influencers in your mortgage rate. As your Mortgage Agent, in my search for the right product and best rate, I take into account 2 very important, but different, key influencers that factor in your mortgage pricing; The Canadian Bond Yield and the Bank of Canada Key Interest Rate. 

If you're considering a mortgage or already have one, you might have heard about the bond yield and its influence on mortgage rates. But what exactly is the Canadian bond yield, and how does it impact your mortgage rate? Let's break it down.

Understanding Bond Yields

A bond yield is essentially the return an investor gets on a bond. In Canada, the government issues bonds to raise funds for various projects and to manage public debt. These bonds are sold to investors, who receive regular interest payments (coupon payments) and the return of their principal at maturity.

The yield on a bond is influenced by several factors, including:

• Interest Rates: The Bank of Canada's benchmark interest rate significantly affects bond yields. When the central bank raises interest rates, bond yields typically increase, and vice versa.
• Economic Conditions: Strong economic growth can lead to higher bond yields, while economic uncertainty or downturns can lead to lower yields as investors seek safer investments.
• Inflation Expectations: Higher expected inflation can lead to higher bond yields as investors demand more return to compensate for the eroding value of money.

How Bond Yields Affect Mortgage Rates

Mortgage rates in Canada, especially fixed rates, are closely tied to the yields on government bonds, particularly the 5-year bond yield. Here’s how the relationship works:

1. Cost of Borrowing for Lenders: Lenders (like banks) use the yield on government bonds as a benchmark for the cost of borrowing money. If bond yields rise, it becomes more expensive for lenders to borrow money, and they pass this increased cost onto borrowers in the form of higher mortgage rates.

2. Fixed vs. Variable Rates: Fixed mortgage rates are directly influenced by bond yields. For example, a 5-year fixed mortgage rate is often priced based on the 5-year government bond yield plus a certain spread to cover lender costs and profit. Variable mortgage rates, on the other hand, are more directly influenced by the Bank of Canada’s policy interest rate.

3. Market Sentiment and Risk Premiums: Bond yields reflect investor sentiment about future economic conditions. When investors are optimistic, they demand higher yields for bonds, leading to higher mortgage rates. Conversely, in times of economic uncertainty, bond yields tend to fall, which can lead to lower mortgage rates.

The Chain Reaction: From Bond Yields to Mortgage Rates

To understand the impact more concretely, let’s look at a simplified chain reaction:

1. Bank of Canada Adjusts Rates: The Bank of Canada changes its benchmark interest rate based on economic conditions. For example, to combat inflation, the Bank might raise rates.

2. Bond Market Reacts: Higher benchmark rates make new bonds more attractive, increasing their yields. Existing bonds with lower yields become less attractive, pushing their yields up as well.

3. Lenders Adjust Mortgage Rates: As bond yields rise, lenders face higher borrowing costs. To maintain their profit margins, they increase fixed mortgage rates.

4. Borrowers Feel the Impact: Potential homeowners or those renewing their mortgages face higher rates, which can increase monthly payments and overall borrowing costs.

Practical Implications for Homeowners and Buyers

Understanding the relationship between bond yields and mortgage rates can help you make informed decisions:

• Timing Your Mortgage: If bond yields are expected to rise, locking in a fixed-rate mortgage sooner rather than later might save you money.
• Choosing Between Fixed and Variable Rates: If bond yields and fixed rates are high, but the central bank’s rate is low, a variable-rate mortgage could be more affordable in the short term.
• Monitoring Economic Indicators: Keep an eye on economic indicators like inflation, employment rates, and the Bank of Canada’s announcements, as these can signal changes in bond yields and mortgage rates.

Bank of Canada Key Interest Rate

The Bank of Canada key interest rate, also known as the overnight rate, is the rate at which financial institutions lend money to each other overnight. This rate directly influences variable mortgage rates and other short-term interest rates. When the Bank of Canada raises the key interest rate, it typically leads to higher variable mortgage rates, increasing the cost for borrowers with variable-rate mortgages. Conversely, a decrease in the key interest rate generally results in lower variable mortgage rates, reducing the cost of borrowing for consumers.

• Fixed-Rate Mortgages: Consumers with or considering fixed-rate mortgages should pay attention to the 5-year Canadian bond yield. A rising bond yield may signal increasing fixed mortgage rates, so locking in a rate sooner might be advantageous.
• Variable-Rate Mortgages: Those with variable-rate mortgages should monitor the Bank of Canada's key interest rate. Changes in this rate will directly affect their mortgage payments.

In conclusion, the Canadian bond yield plays a crucial role in determining mortgage rates, while the Bank of Canada Key Interest Rate directly influences variable rate mortgages.

By understanding this relationship, you can better navigate the mortgage landscape and make choices that align with your financial goals. Stay informed, and you’ll be better prepared to manage your mortgage in any economic environment.

5 year Mortgage Bond Yield can be tracked here: https://www.marketwatch.com/investing/bond/tmbmkca-05y?countrycode=bx