As most readers here know, fixed mortgage rates follow bond yields over time. That's why, with the 5-year fixed being Canada's most popular term, mortgage originators keep close watch on the 5-year government bond yield.
Last Thursday, however, the 5-year yield displayed what some deemed to be a concerning 11-basis-point spike.
The Bank of Canada's website noted the same 11 bps increase.
To an untrained eye, this leap in yield might have been caused by ominous inflationary news (inflation expectations are the #1 factor influencing bond yields).
In reality, Thursday's jump in the 5-year yield was simply the result of a change in the benchmark bond.
Many folks don't understand how this works, but as mortgage professionals we should all understand it. So here's a short explanation:
- The Bank of Canada issues and re-issues 5-year bonds on a regular basis.
- The 5-year bond that is the most liquid and actively traded is generally called the "benchmark" 5-year bond.
- As time goes on, five-year bonds effectively become 4.9-year bonds, 4.8-year bonds, 4.7-year bonds and so on. In turn, a new bond receives benchmark status to ensure its time remaining and coupon (interest rate) best represents a current 5-year maturity.
- In a normal interest rate environment, shorter-term interest rates are lower than longer-term rates. As a bond gets closer to maturity, traders therefore value it at successively lower yields. That's why going from a benchmark with 4.8 years to maturity to one with 5+ years to maturity results in a jump in yield.
- That's exactly what happened this week. After the Bank of Canada auctioned off $3.3 billion of its latest 5-year bond issue, the benchmark changed from the March 2020 bond to the September 2020, bond and the yield on the new benchmark was higher than the yield on the old benchmark.
- Since most charts and quotes of the 5-year government bond are based on the benchmark issue, this week's change in benchmark made it look like the yield jumped 11 bps by the close on Thursday. In reality, this increase had little economic significance.
Sidebar: Interestingly, the yield on the new September 2020 benchmark actually fell this week after the BoC auction. And the yield on the old March 2020 benchmark made a new all-time low.