What is the bond market? Why have interest rates increased so much between 2012 and 2013 on a percentage basis? How does it affect real estate? Why should I care about it?
What is the Bond Market?
As defined by recent Wikipedia updates, the Bond Market is described as follows:
“The bond market (also known as the credit, or fixed income market) is a financial market where participants can issue new debt, known as the primary market, or buy and sell debt securities, known as the Secondary market, usually in the form of bonds. The primary goal of the bond market is to provide a mechanism for long term funding of public and private expenditures.
As of 2009, the size of the worldwide bond market (total debt outstanding) is an estimated $82.2 trillion, of which the size of the outstanding U.S. bond market debt was $31.2 trillion, according to Bank for International Settlements (BIS – The World’s “Superbank”).
References to the “bond market” usually refer to the government bond market, because of its size, liquidity, relative lack of credit risk and, therefore, sensitivity to interest rates. Because of the inverse relationship between bond valuation and interest rates, the bond market is often used to indicate changes in interest rates, or the shape of the yield curve. The yield curve is the measure of “cost of funding.”
The Historical Trends for both Treasuries and Fixed Mortgages
Let me go back further in time to better explain this section about the more recent changes in 10 Year Treasuries which impact the directions for thirty (30) year fixed rate residential mortgages. Interest rates reached their peak highs back in the very early 1980s (1981, especially). In the very early 1980s, the 10 Year Treasury Yield peaked near an insanely high 16.0%, and corresponding 30 Year fixed mortgage rates fluctuated in the 15% to 18% rate ranges.
Bonds are glorified “IOUs” from governments or companies to investors
As a result of the high double digit fixed mortgage rates at the time in the early 1980s, the popularity of seller financing options such as AITDs (All Inclusive Deeds of Trust), Land Contracts or Contracts for Deed, Lease-Options, and “Subject To” deals increased significantly. On a comparative basis, a 12% “Wraparound” or seller financed deal seemed awfully “cheap” as compared with a 16% fixed rate mortgage loan.
The Credit Crisis Trends for both Treasuries and Fixed Rates
Since the official start of the Credit Crisis back in the Summer of 2007 (www.thecreditcrisis.net), we have seen a downward pricing trend for both Treasury Yields and fixed mortgage rates due to some fancy financial games or shenanigans played by the Federal Reserve, such as “Quantitative Easing” (“create money out of thin air in order to buy stocks, bonds, and mortgages”) and “Operation Twist.” With “Operation Twist”, The Fed sells short term bonds while simultaneously purchasing long term bonds, in order to artificially drive Treasury yields and mortgage rates downward.
Near the official start of The Credit Crisis in August 2007, the average 30 year fixed mortgage rate hovered within the 6.5% to 6.6% rate ranges. During the same month of August 2007, the 10 Year Treasury Note Yield was near 4.86%. After asset prices began to implode such as stock and real estate values after the Summer of 2007, then the Fed reacted by trying to make rates much lower in order to try to offset so much asset deflation, which had also hurt Japan back in the 1990s.
Our Last Year’s Treasuries and Mortgage Pricing Trends
Over the past year, the 10 Year Treasuries hit a low of 1.55% (September 3, 2012), and 30 year fixed mortgage rates reached near the low 3% fixed rate ranges. In the week when I write this article (early October 2013), 10 Year Treasuries are somewhere closer to the 2.60 to 2.70% ranges. Additionally, 30 year fixed mortgage rates are closer to the 4.4% + rate ranges today.
When interest rates increase, then there are less qualified buyers who have sufficient income necessary to qualify for these proposed mortgage payments. As a result, more lenders are beginning to offer adjustable rate mortgages with shorter fixed rate durations so that more of their clients may qualify for loans today.
With the double digit annual home price appreciation numbers in many parts of our nation over the past year or two, it can be more challenging for some people to qualify for a mortgage loan with a higher interest rate and payment as well as for a home which may have increased $50,000 to $100,000+ in price in recent times.
I have read a few times in recent weeks that upwards of 50% to 60% of all U.S. home buyers have paid all cash in 2013. If these numbers are fairly accurate, then many sellers seem to prefer selling to all cash buyers as opposed to buyers who need to qualify for a mortgage loan if they are both willing to pay the same price for the property.
Will the Fed “Taper” QE Strategies?
Fed Chairman Ben Bernanke has now suggested several times that the Federal Reserve may soon “taper” off their “Quantitative Easing” (QE) strategies at some point in the “future.” Will it be tomorrow, or possibly years or decades from now depending upon the state of the U.S. economy?
Bonds are glorified “IOUs” from governments or companies to investors. Bondholders are only entitled to a repayment of their principal amount when the bond matures. This can put an upper limit or ceiling on the amount of price appreciation for bonds held by investors today.
Bond prices are falling today partly due to the Fed’s implied “tapering” threat that they may begin decreasing the amount of stocks, bonds, and mortgages that the Fed may purchase each month. Allegedly, the Fed purchases upwards of $85 billion per month of both Treasuries and Mortgage Bonds, so their investment percentages of the overall market are quite significant.
In a rising interest rate market world as today, even though rates are still near historical all-time lows, new bond investors can purchase bonds which offer higher rates and income. For bond holders who currently own bonds at much lower rates from last year, then these same bond investors will have less future buyers for their existing bonds (or “IOUs”).
In basic Economic theories, a decreased number of buyers tends to historically lead to falling prices for any type of product whether it be a bond, real estate, or lemonade from a child’s corner stand. For bonds, falling prices then, in turn, leads to rising Treasury Yields since prices and yields are inverse to one another, and are akin to being on a “see saw.”
Whether the Fed does, in fact, begin tapering off or reducing their investments by way of QE policies or maintains their perceived and potential “QE Infinity” strategies in order to try to continue boosting asset prices such as stocks and real estate values, please keep a close eye on the directions of both the Treasury Yields and mortgage rates so that you have a better idea of the future potential direction of the overall U.S. economy.
Author: Rick Tobin
Rick Tobin has a diversified background in both the Real Estate and Securities fields for the past 25+ years. He has held seven (7) different Real Estate and Securities brokerage licenses to date.
Rick has an extensive background in the financing of residential and commercial properties around the U.S with debt, equity, and mezzanine money. His funding sources have included banks, life insurance companies, REITs (Real Estate Investment Trusts), Equity Funds, and foreign money sources.
You can visit Rick Tobin at RealLoans.com.