The Bond Market and Fixed Mortgage Rates
The Government of Canada bond market is a pillar of the Canadian financial system and the foundation for pricing fixed-rate mortgage loans. A government bond is a debt security issued by the fédéral government to fund its operations. The investor who buys the bond lends money to the government in exchange for a fixed return. Since the Government of Canada is considered a default-free borrower, its bonds serve as the benchmark for all other interest rates in the economy. Bond yields vary based on supply and demand in financial markets, reflecting investor expectations about inflation, economic growth, and future monetary policy.
Why the 5-Year Bond Is the Benchmark
The 5-year mortgage term is the most popular in Canada, representing approximately 60% of all mortgages. This is why the 5-year Government of Canada bond is the most important reference for mortgage lenders. Its yield determines banks' funding cost for 5-year loans. For 3-year terms, lenders refer to the 3-year bond; for 10-year terms (rare in Canada but increasingly offered), it is the 10-year bond. The 5-year bond yield is published daily on the Bank of Canada website and can be tracked in real time on financial platforms.
How Yields Déterminé Fixed Rates
Lenders secure funding through mortgage-backed securities (MBS), Canada Mortgage Bonds (CMBs) issued by CMHC, or directly on the bond market. They then add a credit spread (margin) covering the borrower's default risk, operational costs of administration and origination, prepayment risk, excess funding costs, and the lender's profit margin. The simplified formula is: Offered fixed rate = Reference bond yield + Lender's credit spread.
The Yield Curve: An Essential Analysis Tool
The yield curve plots Government of Canada bond yields against maturity (from 3 months to 30 years). Its shape provides valuable information about market expectations for the economy and monetary policy.
- Normal curve (upward sloping): long-term bonds offer higher yields than short-term. Reflects healthy economic growth and moderate inflation. 5-year fixed rates are higher than 3-year fixed rates, the typical situation.
- Flat curve: yields are similar across all maturities. Signals economic uncertainty and a possible transition between economic cycle phases. Fixed rates for different terms converge.
- Inverted curve: short-term bonds offer higher yields than long-term. This phenomenon has preceded every Canadian recession in the past 50 years. Short-term fixed rates can be higher than long-term rates.
- Steep curve: a large gap between short and long rates signals expectations of vigorous recovery and future inflation. This pushes long-term fixed rates higher.
Factors Influencing Bond Yields
Several macroeconomic factors influence bond yields and, consequently, fixed rates. Inflation expectations are the most important: if investors anticipate higher inflation, they demand higher yields to compensate for purchasing power loss. GDP growth prospects, monetary policy decisions (current and anticipated), US interest rate movements (Canadian and US bond yields are correlated), government fiscal policy (bond issuance), and geopolitical events (creating demand for safe-haven assets like government bonds) are all determining factors.
Practical Implications for Quebec Brokers
By monitoring the 5-year bond yield daily, mortgage brokers can anticipate lender fixed-rate adjustments, often two to five days in advance. When the yield rises significantly over several consecutive days, the savvy broker recommends clients lock in their rate hold quickly. Conversely, falling yields may justify waiting before locking. Brokers must also understand that bond yields and the policy rate can move in different directions: the Bank of Canada may raise the policy rate (increasing variable rates) while long-term yields fall (reducing fixed rates), if the market anticipates a future economic slowdown.