Why Mortgage Rates May Stay Higher For Longer

“Delinquency rates for commercial mortgages backed by office properties continued to increase during the third quarter but declined for loans backed by lodging, retail and industrial properties. The commercial mortgage market is large and diverse, covering a range of property types, sizes and ages, geographic markets and submarkets, borrower types, vintages and more. Each of those differences is affecting loan performance, some to the good and some to the bad.”

-Jamie Woodwell, Head of Commercial Real Estate Research at MBA

Hi Nuvo Community,

Introduction

The relationship between the 30-year mortgage rate and the 10-year Treasury yield is one of the most closely watched metrics in real estate finance. While closely correlated, the spread between these two rates is essential to understanding the cost of borrowing and the risk premiums that lenders demand. Historically, the spread has averaged 1.81%, though during times of economic stress, it has fluctuated widely, as evidenced by the 4.85% spread recorded in April 1980.

However, this relationship is not merely about alignment. Embedded in the mortgage rate and bond yield dynamic is the concept of negative convexity, a critical factor that further complicates how mortgage rates respond to shifts in Treasury yields. This article explores the historical relationship between these two rates, the key statistics surrounding their spread, and the role of negative convexity in amplifying volatility in mortgage markets.

The Spread: A Measure of Risk and Volatility

At its core, the spread between the 30-year mortgage rate and the 10-year Treasury yield reflects the risk premium that lenders demand over the "risk-free" rate. On average, this spread has hovered around 1.81%, but the range is much wider during periods of economic instability.

In April 1980, during the peak of inflationary pressures, this spread blew out to 4.85%, with the mortgage rate sitting at 16.33% and the 10-year yield at 11.47%. This massive spread was driven by several factors, including inflation fears, increased credit risk, and a shift in investor sentiment towards safer government securities. It was a time when lenders demanded extraordinarily high premiums to compensate for elevated risks in the housing market.

In contrast, 1997 saw one of the smallest spreads at just 1.24%, as the economy experienced stable growth and relatively low inflation. The tight spread indicated a lower risk premium demanded by lenders and more predictable economic conditions.

Correlation and the Pace of Movement

The 30-year mortgage rate and the 10-year Treasury yield exhibit a near-perfect correlation of 0.99, meaning they tend to move in the same direction. However, this high correlation doesn't tell the whole story. When analyzing the rate of change, we see a correlation of 0.74%, suggesting that while they generally move together, the pace at which they adjust differs.

Mortgage rates, in particular, tend to move more slowly than Treasury yields due to factors like credit risk, prepayment risk, and regulatory considerations. Mortgage rates reflect the behavior of mortgage-backed securities (MBS), which are sensitive to negative convexity, a phenomenon unique to fixed-income instruments with embedded prepayment options like mortgages. You can see in the chart below how much more the 10 YR (orange) tends to move than the 30YR.

The Role of Negative Convexity in Mortgage Rates

Negative convexity is a crucial factor that affects the relationship between mortgage rates and Treasury yields, especially during periods of falling interest rates. Unlike traditional bonds, where prices rise as yields fall, MBS face the opposite dynamic. When interest rates fall, homeowners are more likely to refinance, leading to early repayment of mortgage-backed securities. This "prepayment risk" means that lenders receive principal back faster than expected, limiting the upside in MBS prices.

As a result, mortgage-backed securities experience negative convexity: the bond price rises less as interest rates drop, and falls more sharply when interest rates rise. This asymmetry in bond price movements translates into slower downward adjustments in mortgage rates, especially when compared to Treasury yields.

Negative convexity also helps explain why mortgage rates are less volatile than Treasury yields in certain periods. The standard deviation of the rate of change for the 30-year mortgage rate is 0.035, compared to 0.064 for the 10-year yield. This lower volatility is due to the prepayment option embedded in most mortgages, which tempers the response of mortgage rates to declining Treasury yields.

This higher volatility for the 10-year yield indicates that it is more sensitive to shifts in investor sentiment and macroeconomic data. In contrast, the 30-year mortgage rate moves more slowly due to the inherent complexities of the mortgage market, particularly the presence of negative convexity. Mortgage lenders are more cautious when adjusting rates, especially during periods of falling interest rates, as they factor in the possibility of mass refinancing.

Largest and Smallest Spreads: Recent Trends

Recent years have seen the spread between mortgage rates and the 10-year Treasury yield widen considerably, primarily due to rising economic uncertainty and aggressive Federal Reserve policies aimed at controlling inflation. In 2023, the spread reached 2.84%, one of the highest in modern times, reflecting lenders' heightened risk premiums as they navigated a volatile economic landscape.

Similarly, 2024 has already posted a spread of 2.53%, while 2022 saw 2.38%. These figures stand in stark contrast to the spreads of the late 1990s, such as 1997, when the spread was just 1.24%, and 1994, when it was 1.27%. The larger spreads in recent years are symptomatic of a market still grappling with post-pandemic volatility, inflationary pressures, and the uncertainty surrounding future interest rate policies.

Conclusion

As the data shows, negative convexity creates a unique challenge in the mortgage market, particularly during periods of falling interest rates, as lenders charge a premium to offset the risk of prepayment. This risk leads to higher mortgage rates even as Treasury yields drop, widening the spread and raising borrowing costs for potential homeowners.

Higher mortgage rates have implications for other markets, particularly for apartment demand. As mortgage rates rise and affordability declines, fewer people can purchase homes, pushing them toward the rental market. Even in the face of generational oversupply of apartment units, absorption continues to be resilient. Multifamily CRE should have strong tailwinds supporting values toward the end of 2025 and beyond – unattainable housing leading to strong absorption and no new supply.

All the best,

Yuri - Your Real Estate Investigator

Credit: Brian Underdahl, Chief Executive Officer, Nuvo Capital Partners

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