If you haven’t heard, the 30-year-old constant is again above 7%, at least by some accounts.
After settling around 6.5% in early May, mortgage rates have been rising steadily over the past two weeks.
At the same time, the spread between the 30-year Treasury yield and the 10-year Treasury yield widened to levels well above historical benchmarks.
There is always a premium to mortgages versus government bonds because the latter are guaranteed to pay back.
But the gap between the two is now nearly double the average, which begs the question, why?
The relationship between mortgages and the 10-year treasury
First things first, let’s discuss why 30-year mortgages and 10-year Treasurys have a relationship to begin with.
Without complicating here, mortgage-backed securities (MBS) and 10-year Treasury notes engage regular investors.
After a home loan fund, these are usually bundled as mortgage-backed securities (MBS) and resold.
While these mortgages have 30-year loan terms, which is three times the length of a 10-year bond, they often pay off faster.
This is due to a variety of factors, whether it’s refinancing a mortgage, selling a home, or simply paying off a mortgage early.
In short, the average mortgage only lasts about a decade, making it a good match in terms of duration for a 10-year-old.
However, investors demand a premium for taking on the risks of mortgage-backed securities versus government bonds, as shown in the FRED chart above.
The red line is the 10-year Treasury yield and the blue line is the 30-year fixed interest rate average.
This risk is represented by spreads, which have historically been about 170 basis points over the 10-year bond yield.
MBS investors earn a greater return due to things like defaults and foreclosures.
Mortgage spreads are nearly double the historical base
Recently, investors have demanded more compensation for taking Mohammed bin Salman’s risks.
The current spread has widened to about 325 basis points over the 10-year yield.
This morning, the 10-year yield was hovering around 3.73%, while the 30-year fixed yield was priced around 6.98% per MND.
Simply put, MBS investors demand nearly twice the usual premiums to take on mortgage risk versus government bonds.
So instead of seeing a 30-year flat rate of, say, 5.5%, potential homebuyers are faced with mortgage rates in the high 6s and up to 7%.
This obviously erodes affordability and drives a lot of potential buyers over the fence.
This begs the next logical question; Why is the difference so now?
Increased risk and uncertainty resulted in inflated spreads
There are a variety of reasons why mortgage spreads are currently so high compared to Treasuries.
But almost all of them have to do with increased risk and uncertainty.
Remember that government bonds are guaranteed to be redeemed. And its duration is also locked. If it is a 10-year bond, it is repaid within a decade.
Conversely, the recovery of Mohammed bin Salman cannot be guaranteed, and its duration is not determined due to early returns, house sales, defaults, and so on.
While this uncertainty has always existed, the recent banking crisis has made MBS investors more volatile.
If you remember, the banks that went through it (First Republic for example) had a mismatched tenure, as they had a lot of long-term debt with very low fixed rates.
Meanwhile, depositors demanded higher returns on their funds, which caused liquidity problems when they withdrew their funds en masse.
The basic problem is that mortgage rates today are much higher than those underwritten a year or two ago.
We are talking about interest rates at 6-7% versus rates in the 2-4% range previously. This means that those lower rate mortgages will most likely last for a very long time.
The increased term is nice when the interest rate is high, but clearly not so good when many savings accounts now yield 4-5%.
At the same time, there is an assumption that many newly created mortgages set at 6-7% will be relatively short-lived.
So investors wouldn’t pay a premium on the underlying bond, only to have it paid off within a year once mortgage rates calm down and get back to 5%.
Combined, MBS investors are demanding more returns. And because the Fed is no longer a buyer of Mohammed bin Salman, demand is generally lower.
(photo: k)
