What are Government Bonds?
Government bonds are essentially I.O.U’s issued by the government to fund their public programs. These I.O.U’s provide a great option for investors with excess cash looking for a safe place to park their money to generate a return on their investment (rate-of-return). Because bonds are backed by the Canadian government and the government has never defaulted on their debt, these bonds are considered to be risk-free.
- A bond is sold in various durations, from 1-year up to 30-years.
- The rate-of-return a bond provides is called the bond’s yield.
- The bond’s yield is determined by two components: the bond’s price, and the bond’s coupon rate.
The bond’s price is the amount an investor will pay for the bond, and the coupon rate is the amount of interest the bond will pay the investor annually. When you account for the bond’s price and the coupon rate, we have the rate-of-return the bond provides, also known as the bond’s yield.
When inflation is higher than the bond’s yield, a smart investor will not purchase the bond because they understand their money’s purchasing power is decreasing with this investment.
For a bond to be competitive in a high inflation market, the bond yield needs to exceed the rate of inflation. To achieve this, the bond’s price needs to decrease, or the bond’s coupon rate needs to increase, or both.
How do Government Bonds affect Mortgage Rates?
Over the last 6-months (November 2022 – April 2022) we’ve noticed inflation exceeding Bank of Canada’s average target inflation rate of 2%. The bond market is reacting accordingly and bond prices are dropping which is causing bond yields to increase. Since fixed mortgage rates are positively correlated with bond yields, any increase to bond yields means an increase to fixed mortgage rates.
Links to Current Bond Yields