Current 5-Year Bond Yield has been highlighted.
Government bonds are a relatively safe investment, and in terms of Canadian and U.S. government bonds, they can even be considered to be risk-free. The government bonds are issued with maturities ranging from 2 to 30 years. The 5-Year Government of Canada bond yield is particularly important for homeowners, as 5-year fixed-rate mortgages follow the bond yield. Government bonds of different maturities, such as 5-year bond yields and 10-year bond yields, are also used by analysts to assess the conditions of the economy.
Government bonds are risk-free investments, while mortgages are risky investments. To make up for the risk, there is a risk premium added onto mortgage rates above bond yields. This compensates investors for the additional risk that they take on.
5-year bonds have the same maturity as 5-year fixed mortgages. But in the case of mortgages, part of the principal is paid back every month, while for government bonds, the principal is only paid back at maturity. For example, with an interest rate of 5% and amortization of 25 years, 11.3% of the mortgage loan will be paid back during the first five years. With a 20-year amortization, 16.3% will be paid back during the first five years, while this number increases to 25% with a 15-year amortization. At a lower interest rate of 2% with a 25-year amortization, 16.2% of the principal will be repaid in the first five years.
Thus, mortgage loans have an effective term shorter than their nominal term. If given these two options, an investor can either invest in the 5-year bond and receive a safe return, or they can invest in mortgages. Mortgages have additional risks in a variety of ways. They have default risk, where the homeowner cannot afford to make payments, and there is prepayment risk, where a homeowner pays back the mortgage early.
There are prepayment penalties if a mortgage is paid back early, but most Canadian mortgages give the borrower some prepayment privilege. Prepayment privileges are typically between 10% and 20% of the mortgage principal yearly. If interest rates in Canada rise significantly, prepayment privileges are unlikely to be used. But if interest rates fall, prepayment privileges provide potential savings to borrowers and are risky for lenders. Thus prepayment risk is higher when the forecast of interest rates is for them to fall.
If 5-year bond yields increase, then 5-year fixed-rate mortgages will also increase. The reverse is also true, however mortgage lenders can be inclined to increase rates faster when yields rise rather than decrease them should bond yields fall.
Mortgage rates follow the bond yield, but there is a spread between them. This spread is usually between 1-2%. This means that if the current 5-year bond yield is 1%, then we can expect 5-year fixed closed mortgage rates to be around 2-3%.
For example, on February 1, 2021, the benchmark 5-year bond yield was 0.42%. We can then expect mortgage rates to be between 1.4% and 2.4%, which they roughly were.
|5-Year Canada Bond Yield||Last Seen||Mortgage Rates Range|
|0.4%||January 2021||1.4% - 3%|
|1.6%||March 2022||2.6% - 3.6%|
|3%||May 2023||4% - 5%|
This spread can widen during times of financial uncertainty, as investors move towards safer investments such as government bonds. In March 2020, as the COVID-19 pandemic affected Canadian markets, some lenders briefly increased mortgage rates even though bond yields fell.
The same mortgage spread movement was seen in the United States. The 30-year mortgage rate spread above the 10-year Treasury yield increased from just under 1.8% in January 2020 to over 2.72% on April 23, 2020. This 2.72% spread over the Treasury yield was a record high not seen since 2008.
The most important interest rate in the Canadian economy is the overnight interest rate. As a result, the Bank of Canada conducts its monetary policy by controlling the overnight rate. Also, Canadian financial institutions set their prime lending rate with reference to the overnight rate.
Overnight lending uses the Government of Canada (GoC) bonds as collateral. As a result, lending money in the overnight market is almost as safe as investing in GoC bonds. Thus in principle, an investor should be indifferent to lending their money overnight over the next five years or purchasing GoC 5-year bonds.
The term structure of interest rates is explained by the expectation hypothesis. The expectation hypothesis considers the return from holding a long term bond until maturity to be the same as the return from rolling a series of short term bonds if the total term to maturity of the short term bonds is the same as the term to maturity of the long term bond.
Based on this hypothesis, long-term yield is the average of expected short-term yields. Similarly, the forward rate is the expectation of future short-term rates.
The expectation hypothesis neglects the interest rate risk.
If you calculate the bond yield till maturity, you are taking on liquidity risk, otherwise considerable interest rate risk. Because the nominal return on a long term bond sold before maturity is uncertain. Investors may demand compensation for taking on this risk.
Any deviation from the expectation hypothesis is called “term premium”.
In other words, the yield to maturity of the GoC 5 year bond should correspond to the average of the expected overnight rate during the next five years. When setting monetary policy, our central bank thinks about the neutral rate. A neutral rate is an overnight interest rate which does not stimulate the Canadian economy, nor does it slow down the economy.
BoC can slow down the economy by setting its policy rate above the neutral rate. It can stimulate the economy by setting its policy rate below the neutral rate. The neutral rate is the real neutral rate plus the inflation rate. Unfortunately, it is impossible to measure the neutral rate. BoC makes very sophisticated models of the economy to estimate the neutral rate.
Its current estimate of the real neutral rate is between 0 and 1%. Since the BoC’s primary target is the rate of inflation, it would be setting the neutral rate when inflation is at (or close to) its 2% target. This means the neutral policy rate is expected to be between 2%-3% over the medium to long term.
During 2020 and 2021, the target overnight rate was at 0.25% to counter the effect of the Covid-19 pandemic on the economy. Large fiscal spending coupled with loose monetary policy during the pandemic resulted in high inflation in 2022 and 2023.
In March 2022, BoC started raising rates to subdue inflation. By September 2023, the policy rate has reached 5%, while inflation has slowed to 4%. Thus, the real policy rate seems to have reached 1%. In reality, the real rate of interest is higher because inflation is expected to decline over the next few quarters. We do expect inflation to decline and the overnight rate to follow it lower. Thus the 5-year bond yield will likely decline over the next few years. We can look at the bond market to get an idea of the expected decline in 5-year yields. As of September 18, 2023, 1 Year, 2 Year, 3 Year, 5 year, 7 year and 10 year, GoC bonds were respectively 5.05%, 4.73%, 4.38%, 3.98%, 3.84% and 3.76%. Suppose we assume that an investor would be indifferent between receiving a certain return from a longer-term bond or two shorter-term bonds purchased successively. In that case, we can see that the 5-year yield is expected to decline to around 3.49% in two years and then slightly climb to around 3.54% in 5 years.
The yield of a bond is an annual return that the bond provides in percentage terms. The yield of a bond is not just the interest that you receive, but also takes into account the market price of the bond versus its face value.
Government of Canada bonds pay interest every six months. This is known as coupon payments. Each bond has a face value, with the bond's coupon rate being a percentage of the bond's face value. The bond’s coupon rate does not change over the life of a bond, but the price of the bond can change, in turn affecting returns. Generally, bonds with longer maturities will be more sensitive to market interest rate changes, and will have larger price changes than shorter maturity bonds.
The bond’s face value, or par value, may not be the same as the price that you paid for the bond. If you purchased a bond below face value, you will get a yield higher than the coupon rate. Conversely, paying more than the bond’s face value will mean that you will have a yield lower than the coupon rate.
Government of Canada bonds are regularly issued through auctions. In these bond auctions, primary dealers bid on the price of the bond that they are willing to pay, given a set coupon rate.
Some primary dealers include RBC, TD, Scotiabank, CIBC, BMO, HSBC, Desjardins, and National Bank. Primary dealers are the only ones authorized to bid directly in Government of Canada bond auctions, and so they set the price for the market. Primary dealers are also Government Securities Distributors. These Government Securities Distributors then sell these bonds to clients.
The 5-Year Government of Canada bond is auctioned off roughly every month. For example, the 5-year bond was auctioned on January 14, February 11, March 9, and March 31 of 2021. These bonds will mature in five years, in 2026.
Government of Canada bonds are priced with a par value of $100, although they have a face value of $1,000. For example, if a bond is priced at $99.50, one bond would cost $995.
During auctions, if primary dealers feel that the set coupon rate is too low for current market conditions, then they may bid for a price lower than par. For example, the 5-year bond auctioned on January 14, 2021 had a coupon rate of 0.25%. The result of the auction was an average price of $98.719. Since the price is lower than par, the resulting bond yield is higher than the stated coupon rate. The yield for that particular bond was 0.504%.
If a bond’s coupon rate is attractive, dealers may bid up the price, as they are willing to pay more to get a higher coupon rate. For example, the 30-year bond auctioned on January 21, 2021 had a coupon rate of 2.00%. The resulting price of the auction was $112.285, well above par. This reduced the bond’s yield to 1.501%.