Aug 142019

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By G. Steven Bray

Trade uncertainty last week set off a feeding frenzy in the bond market. Investors gobbled up Treasury bonds in a flight-to-safety buying spree that saw the 10-year rate drop by 40 basis points (0.4%) in just over a week. The 10-year rate is now the lowest it’s been since 2016.

Given that we always talk about mortgage rates tracking the 10-year Treasury, shouldn’t mortgage rates be looking superb right about now? Well, not exactly. While mortgage rates tend to move in the same direction as the 10-year T-bill, there’s one big reason that mortgage rates lag behind when it comes to rapid rate changes.

When an investor buys a 10-year Treasury bond with a 2% rate, the investor knows that bond will pay 2% interest for exactly 10 years. Period.

When an investor buys a 30-year mortgage security with a 3% rate, the investor knows it will pay 3% for 30 years if and only if the borrower doesn’t sell, refinance, die. Of these, refinancing is the greatest risk when rates are moving lower.

Let’s say an investor buys a mortgage security with a loan balance of $1 million paying 3%. The investor expects to receive payments equal to the loan balance PLUS the interest paid on the loan, so the investor pays $1.04 million for the security – a premium to account for interest.

Now, let’s say rates keep dropping, and the borrower refinances after 12 months. The borrower has paid roughly $30k in interest, but the investor paid a $40k premium. Not a winning investment strategy.

Investors still want to purchase mortgage securities, so what do they do? They reduce the premium they’ll pay. The way this shows up for borrowers is in the interest rate.

In the example above, it takes $40k of premium to make everyone whole in the mortgage transaction. If the investor only offers $30k, the lender needs to make up the extra $10k, and it does that by offering the investor (and, thus, the borrower) a slightly higher interest rate – thus inducing the investor to pay the required premium.

Now, the borrower will see a lower rate than before rates fell because the cost of money is lower, but the borrower’s rate won’t fall as quickly as that of more predictable bonds, such as Treasuries.

If Treasury rates settle into the current range for a while, the refinancing risk will abate, and mortgage rates eventually will catch up.

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