Monday, September 8, 2014

30-year FRM versus 10-year Government Bonds.

Question:  Consider two different measures of the spread between the 30-year FRM and 10-year U.S. government bond rate.   The first measure is the difference between the two rates.   The second measure is the percentage difference of the 30-year FRM over the 10-year bond rate.

How have the rates on these assets varied over time based on the spread and the percentage spread?

When were these spreads low?   When were they high?   What is the current market condition?  

What are potential implications of these numbers for homebuyers and for investors?

Data:  The date for this post covers the period from January 1978 to July 2014.  The source of data for the 30-year FRM was the Freddie Mac Corporation. 


The source of information on the 10-year U.S. government bond is the Federal Reserve Bank of Saint Louis.


Analysis:    In general all interest rates are now low.    Mortgages entail greater risk than U.S. government bonds so the 30-year FRM should always be larger than the 10-year bond rate.  (Maybe a Republican Congress can change this!!!!!!)  

Regardless, in a high interest rate environment (like the one that existed in the early 1980s) the difference spread (30-year FRM-10-year Bond rate) is high but the percentage spread (30-year FRM/10-year bond – 1) is low. 

Right now rates are low and the situation is reverse.  The most recent data (July 2014) has the difference spread inside the inter-quartile range and the percentage spread substantially above Q3, probably around the 90th percentile.


30-year FRM- 10-year Bond
(30-year FRM
/10-Year Bond -1)
Average
1.76
0.33
STD
0.50
0.21
Skew
1.92
1.90
Min
0.53
0.04
Max
4.85
1.32
Q1
1.43
0.19
Q3
1.98
0.40
Range
4.32
1.28
Inter-quartile Range
0.55
0.21
July 2014
1.59
0.63


The percentage spread 30-year FRM was fairly low in the 1980s when interest rates were really high.  1980 M2 the number was 5%.     1984 M5 the number was 4.0%.

The percentage spread was especially high in 2008 and 2009 at the beginning of the financial crisis and at 2012 around the election.   On occasion over this time period the percentage spread was over 100%.

Note that 50% of the time the percentage spread is between 19% and 40%.   (this is defined by the interquartile range.)


Discussion:  The numbers presented here and a previous post comparing the 15-year FRM and the 30-year FRM suggest to me that the 30-year FRM is expensive. 


 Both a 10-year bond and a 30-year FRM fall in value if interest rates rise.   Increases in rates would decrease prepayments in a pool of 30-year FRM.  However, given the current rate differentials it appears as though a diversified and insured 30-year FRM pool will provide better returns than the 10-year government bond.  

Actual outcome will depend on prepayments. 




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