Understanding the Mortgage Market - 10 year Treasury and 30 Year Mortgage Rates

Here is a good piece I received today - Understanding the Mortgage market - specifically, the differences between the 10-year Treasurey and the 30 Year Mortage Rate Good information, easy to understand.

Secondary 101: 10 Year Treasuries and 30 year Mortgages

"I have been watching the 10 year Treasury and we should be getting a rate change soon"

"The 10 year Treasury yields were lower, but 30y conforming rates worsened"

These are typical statements that Secondary Marketing hears regularly from originators and managers. The article below, addresses these statements and will help clarify the relationship that exists between the 10 year Treasury and 30y Mortgage rates.

A 10 year (10y) Treasury is a note that is issued by the United States Treasury to help finance or fund the operations of the federal government. Treasuries are backed by the full faith and credit of the United States and are guaranteed to pay investors their principal amount invested at the end of the term along with a coupon payment (interest) twice a year for the life of the note.

For example, if you buy a $1,000 face value 10y Treasury with a Coupon of 5%, you can expect to receive $25 in coupon payments every 6 months, or $50 a year for 10 years, and at the end of the 10th year, you will also receive your $1,000 back. The overall yield a 10y treasury provides is the overall return that the issuer can expect from holding the note until the maturity date and collecting all of the interest or coupon payments. Note: the coupon payment or interest rate will not equal the underlying yield of a 10y Treasury unless it is priced at 100.00 or "par". Yields and coupon payments are usually different.

A 30 year (30y) Mortgage is a loan from a lender to a borrower in order to buy or refinance a home. The underlying collateral for the transaction is the value of the home and backed by the borrowers' ability to repay the loan. Mortgages are bundled together (pooled) and sold as a mortgage backed security (MBS).

So, the $225,000 loan that you originated and closed last month is packaged with loans that were originated and sold as a security to an investor. A ypical 30y fixed rate mortgage pays a fixed payment every month for the life of the loan including both principal and interest that is remitted to the investor.

Note: the underlying yield for a mortgage security will vary depending on the level of overall rates and the coupon payment or interest rate the loan pays.

A 30y Mortgage works very differently than a 10 year Treasury and these differences add an element of risk to the investment.

First, mortgages are not backed by the United States government. Mortgages are backed by the underlying collateral, the value of the home.

Second, mortgages pay the interest and the principal amount every month to the investor vs. a Treasurythat only pays interest twice a year and the principal at the end of the Note.

The third major difference is a mortgage can be prepaid at any time. The amount borrowed from the investor can be paid back at any time by selling your home, refinancing, or just paying off the balance you owe.

These three major reasons differentiate mortgages significantly from a 10y Treasury and require a higher yield from investors to compensate them for the underlying risks a mortgage has over a Treasury.

Now that we have the basic definitions clarified we can focus on the relationship between the two.

A common misconception is mortgage lenders price their 30y mortgage rates to the 10y treasury.

This is not true. Mortgage Lenders price their 30y mortgage rate to 30y Mortgage securities. 30y

mortgage securities are an independent asset class that competes directly with the 10y Treasury.

Treasuries are the gold standard for fixed income and conservative measurable investing. Other fixed income asset classes (mortgages, municipal bonds, corporate bonds, etc.) compete directly with Treasuries for the yields and returns they provide for potential investors. Most of these "other" fixed income assets trade at a spread to the 10y Treasury because they have more risk (they are not backed by the United States government).

For example, a 30y mortgage with a yield of 6.375 has a 1.375 spread to a 5% Treasury. or to state another way, it trades 137.5 basis points above the 10y. These spreads define what an investor is willing to pay for a given return.

Let's focus on spreads and what they really mean.

Over the past two years, mortgage spreads have been very volatile and reached historic highs. In fact, mortgages have traded as high as 200 basis points above the 10y. Currently spreads are about 150 basis points above the 10y.

What this means is investors want to be compensated more for the current underlying risk and conditions that exist in the mortgage market. A mortgage security is riskier to own and investors want to be compensated for this risk. The average yield spread at which mortgages have traded over the last 10 years has been around 133 basis points or 1.33 points above the 10y treasury yield. From a historical perspective, this means if the 10y treasury yield is 5.00%, then the 30y mortgage was around 6.375. An investor could expect to make 6.375% return for buying a mortgage.

What causes these spreads to change? The spread differences between 10y treasury and mortgages are directly related to investor's appetite and the willingness to accept a given yield.

As stated earlier, mortgage securities compete with many other asset classes for investor attention in their search for the best yields and returns for their money. Stocks, foreign securities, corporate bonds, municipal bonds, Treasuries, and any other asset class that provides returns for the investment community are competing with each other. The ebb and flow of spreads for mortgage securities are a direct link to supply/demand.

Inflation concerns and volatility are two of the worst things a fixed income investor can have. The events over the past three years in the financial markets has led to enormous volatility in the spreads we have seen.

To summarize, mortgages are an independent asset class that trades at a spread to the 10y Treasury. This spread will depend on a number of factors, but primarily it is driven by supply/demand of the investment community. Historically, mortgages correlated to the 10y treasury 80% of the time.

What this means is if the 10y treasury yields are down, historically, mortgage yields were down 80% of the time.

Over the past couple of years mortgages are only correlating 60% of the time. Another way to say this: If 10y yields are down, 6 out of 10 times mortgage yields are down too. Overall, the 10y Treasury is a good indicator in the direction of rates but not in the overall movement of rates. Unfortunately, there is not a good website that posts MBS pricing, but the 10y is a great indicator in the direction of yields and therefore, pricing.

(Questions? Just let me know and we can discuss further. Kathleen)