30-year mortgage vs. 30-year government bond

Abstract

Recently, the market's expectation for the adjustment of existing home loan interest rates has risen again, and bond market investors are concerned about the following issues: 1) Stimulative real estate policies will boost economic growth expectations, which is bearish for the bond market; 2) From the perspective of bank credit-bond price ratio, it will further increase the relative value of bonds, especially long-term bonds, which is bullish for the bond market; 3) From the perspective of bank net interest margin, it requires banks to reduce liabilities (MLF, OMO, deposit rates), which presents a contradiction with the current control of long-term interest rates. How should we view the impact of this policy on the pace and structure of the bond market?

l The supply and demand of home loans determine interest rate prices, which in turn determine the pace of monetary policy, rather than monetary policy determining interest rates. There are many views in the market that believe monetary policy interest rates determine market rates. Over the past two years, we often find that after weaker data on residential medium and long-term loan social financing, there is a pairing relationship with adjustments in monetary policy interest rates. In fact, this implies that market supply and demand determine the causality of policy interest rates. There may be a view in the market that even a rate cut may not boost real estate sales. From a commodity supply and demand framework perspective, whether a rate cut is effective seems unimportant. What is important is that there is an issue of insufficient demand for the commodity itself, and when demand decreases, the price of the commodity tends to decline.

l As a commodity, home loans are facing a significant decrease in demand, requiring 1 ) price reductions, 2 ) and volume reduction. Due to policy interest rates, after the delay in price reductions, it can only be achieved through more volume reduction and early repayment. We can see the trend of early repayment from the underlying asset pool of RMBS and the stock of housing loans of listed banks, which further catalyzes the downward adjustment of monetary policy following the quantity. Therefore, we believe that solid research on the supply and demand relationship of home loans can predict the pace of monetary policy.

l Resident asset yield- debt cost continues to invert, shifting from rational financial choices to irrational security and hedging needs. Currently, residents face a significant decrease in asset-side yields, forming a large inversion with rigid costs on the debt side. We have calculated the comprehensive yield on the resident asset side and the comprehensive cost on the resident debt side. Since 2020, we have found that these two have formed a significant "inversion," with the current degree of inversion close to 70 basis points. From the most basic intertemporal financial optimization perspective, cash repayment of debt is a very rational choice. In addition, from recent market exchanges, the behavior of early repayment of home loans has risen from simple rational financial calculations to hedging needs brought about by insecurity about future income.

l Bank asset-liability perspective: With the adjustment of existing home loan interest rates, deposit rates still need to decline. Early repayment of loans accelerates the reduction of banks' high-quality, high-yield assets, and the adjustment of existing home loan rates directly reduces the yield of banks' high-yield assets. From the bank's perspective, it is all losses and interest margin contraction. Therefore, the static logic that "the bond market is constrained by the cost of bank liabilities" is, the dynamic logic is that deposit rates must be lowered in a "left foot stepping on the right foot" manner How do long-term interest rates affect mortgage rates? Residents' negative income may determine that there is still a significant downward adjustment space for weighted mortgage rates. In terms of magnitude, the downward adjustment of existing mortgage rates may be around 60-80 basis points. After the adjustment of real estate relaxation policies in August last year, the weighted average rate was 4.27%, while as of June 2024, the weighted average interest rate for individual housing loans from financial institutions was 3.45%. There is still a compression space of 82 basis points between existing and incremental rates. On the other hand, based on the disclosed data of listed banks on medium and long-term loan yields, the current average level is around 4.17%, indicating a further 70 basis points of space to decrease to the current 3.45% loan rate level.

So, how does the downward adjustment of existing mortgage rates affect bond market rates? It is positive for long-term interest rates. From the perspective of credit-bond price logic, although long-term rates are currently at historical lows, the cost-effectiveness compared to loans is still higher. By calculating the level of asset Economic Value Added (EVA), the 30-year government bond is at 2.31% compared to the 1.93% of mortgage loans, indicating that government bonds have a relatively advantageous cost-effectiveness compared to credit. If mortgage rates decrease, the cost-effectiveness of long-term bonds will be further highlighted. In terms of trends, the decrease in loan rates may lead the significant decline in bond rates. Therefore, an 80 basis point reduction in mortgage rates may correspond to a decrease of around 20 basis points in the 30-year government bond yield in the medium to long term.

Building on the above logic, how should we understand the central bank's persistence in controlling long-term interest rates? We may consider controlling the speed of the downward adjustment of long-term interest rates, coordinating monetary policies with adjustments in existing mortgage rates, and supporting economic policies as three orthogonal events to understand bond trading.

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Recently, the market's expectations for adjustments in existing mortgage rates have risen again, and bond market investors are concerned about the following issues: 1) Stimulating real estate policies will boost economic expectations, which is bearish for the bond market; 2) From the perspective of bank credit-bond price, it will further increase the relative value of bonds, especially long-term bonds, which is bullish for the bond market; 3) From the perspective of bank net interest margin, it requires banks to reduce liabilities (MLF, OMO, deposit rates), which presents a contradiction with the current control of long-term interest rates. How should we view the impact of this policy on the pace and structure of the bond market?

1. The supply and demand of mortgage loans determine interest rate prices, which in turn determine the pace of monetary policy, rather than monetary policy determining interest rates.

1.1 How is the current situation of mortgage repayments?

Major listed banks are facing early repayment shocks, with most mortgage balances declining and non-performing loan ratios rising. Among the 19 listed banks in the first and second tiers of the real estate loan concentration management system, 14 banks saw a decline in individual housing loan balances in the first half of 2024 compared to the end of 2023, with Bohai Bank experiencing the largest decline at -3.85%. In addition, due to factors such as the sluggish real estate market, slow economic growth, and reduced household income, the non-performing loan ratios of large and medium-sized listed banks are increasing, leading to a decline in bank asset quality From the perspective of different types of banks, the impact of early repayment is more pronounced on the six major banks, while the pressure of early repayment on joint-stock banks is weaker, but the average non-performing loan ratio has increased significantly. As the main force in issuing mortgage loans, except for Postal Savings Bank of China, the outstanding balance of personal housing loans of the other five major banks has been on a downward trend since the end of 2022. In the first half of 2024, among the 13 banks classified as the second tier, only 3 banks saw an increase in the balance of personal housing loans compared to the end of 2023, while the loan balances of other banks declined, with a relatively small decrease in scale. In terms of non-performing loan ratios, data disclosed by many banks showed an increase, with the average level of the second tier rising by 0.19 percentage points compared to the end of last year.

Looking at the underlying asset pool of the existing RMBS, the prepayment rate is generally on the rise. The prepayment rate refers to the proportion of borrowers who repay their loans early in mortgage-backed securities. The significant jump in the prepayment rate in September 2023 was due to the policy impact of the reduction in interest rates on existing first-home mortgages. As of July 31, 2024, the annualized average prepayment rate of existing RMBS reached a historical high level of 23%, up from around 20% at the beginning of the year.

In fact, since the second half of last year, the balance of personal housing loans has entered a downward channel, with residents showing a strong willingness to repay early. The year-on-year growth rate turned negative starting from June 2023, and by the end of the second quarter of this year, the balance of personal housing loans decreased by 2.1% year-on-year, marking the largest quarterly decline since 2020. The decline in housing loan balances indicates an intensification of early repayment phenomena, confirming the rise in the prepayment rate. The possible reason is that the decline in incremental mortgage rates is greater than the decline in existing mortgage rates, leading to a strong willingness of residents to repay early. From this perspective, the downward adjustment of existing mortgage rates is necessary and reasonable.

1.2 How to understand from the perspective of commodity supply and demand?

Many market views believe that monetary policy rates determine market rates. Over the past two years, we often find that after the issuance of relatively weak social financing data for medium and long-term loans to residents, there is a pairing relationship with the adjustment of monetary policy rates. In fact, this implies that market supply and demand determine the causal relationship of policy rates.

If we do not consider the reduction in mortgage rates as a result of monetary policy easing, but look at it from the perspective of commodity supply and demand, then it is the supply and demand situation in the real estate market that determines the price level, namely mortgage rates. Therefore, in the supply and demand structure, a decrease in demand will lead to a decrease in commodity prices However, if at this time, commodity prices do not decrease under the constraint of exogenous regulatory forces, it will be reflected as a significant reduction in quantity, which is exactly the situation that the real estate sector is facing. For example, the decrease in the balance of housing loans as mentioned earlier. The supply and demand of credit determine the level of medium and long-term interest rates, and monetary authorities need to adapt to the fundamental cycle. Furthermore, the supply and demand of real estate determine the long-term interest rate level.

There may be a view in the market that even if interest rate cuts may not boost real estate sales. We believe that from the perspective of the supply and demand framework of commodities, whether interest rate cuts are effective seems to be unimportant. What is important is that there is an issue of insufficient demand for the commodities themselves. When demand decreases, commodity prices will tend to decline, and we may still be in this process. From the sales data, the transaction area/number of commercial housing in the 30 major cities is still in the negative range year-on-year, with year-on-year growth rates of -24.31%/-20.64% in August. In July, the year-on-year growth rates of commercial housing sales and sales area decreased to -18.52% and -15.39% respectively, indicating a relatively low business climate, reflecting that residents' willingness to buy houses is still weak.

As a commodity, housing loans are facing a significant decrease in demand, requiring the movement of the supply and demand curve 1 ) price reduction, 2 ) volume reduction. Due to policy interest rates, if price reduction is slow, then it can be achieved through more volume reduction and early repayment. We can see the trend of early repayment from the underlying asset pool of RMBS and the outstanding housing loans of listed banks, which further catalyzes the downward adjustment of monetary policy following the quantity. Therefore, we believe that a more solid study of the supply and demand relationship of housing loans can predict the pace of monetary policy.

1. The potential logic of the decline in housing loan interest rates: It is difficult for residents' asset-liability inversion to continue

Currently, residents are facing a significant decrease in asset-side yields, forming a large inversion with rigid costs on the liability side. Based on the structure of residents' asset-liability balance sheet over the years and the level of interest rates on various assets and debts, we calculate the "scissors difference" between residents' weighted debt costs and weighted asset yields. The asset side mainly considers housing, wealth management, and trust products. Among them, physical assets mainly consider housing, and use the two-year annualized return on housing prices and the expected increase in housing prices to calculate the return on housing investment; financial assets mainly consider wealth management products and trust products. Debt costs mainly include housing loan rates and other general loan rates. From the calculation results:

Since 2018, residents' weighted asset yield has entered a downward channel. According to calculations up to June this year, the yield level has fallen to around 3%, a historical low. The downward speed of the corresponding weighted debt costs is relatively slow, and since the end of 2019, residents' asset yield and debt costs have shown a significant "inversion", with the current degree of inversion close to 70 basis points

Under the inverted yield curve, from the most basic perspective of cross-period financial optimization, cash repayment of debt is a very rational choice.

1. From the perspective of debt cost: The main debt cost is mainly mortgage-related. The mortgage interest rate has decreased from 4.7% at the end of 2015 to 3.45% in June this year, a decrease of about 125 basis points (BP). However, compared to the weak real estate sales in 2013-2014, there is still a gap in the speed and magnitude of the decline. The decrease in mortgage interest rates from the end of 2015 compared to the end of 2013 was 183 BP, while the decrease in June this year compared to June 2022 was 117 BP.

2. From the perspective of assets: The yield of resident assets represented by bank wealth management has significantly decreased since the end of 2015. As of August this year, the average monthly expected yield of wealth management products for 3 months is around 2%, a decrease of nearly 250 BP compared to the end of 2015. The weighted average asset yield calculated using rental income, wealth management, and trust yields has decreased from 5.4% at the end of 2015 to the current 3.1%, a decrease of nearly 240 BP, forming an inverted yield curve of close to 120 BP with the decline in mortgage interest rates.

The continuous inversion of resident asset yield and debt cost has transitioned from rational financial choices to irrational security and hedging needs. The above is only a financial logic. From recent interactions with the market, many people feel very insecure simply because they have a lot of debt. The behavior of repaying mortgages early may have shifted from simple financial calculations to the need for debt reduction due to insufficient security in future income. Looking at the questionnaire survey of urban depositors published by the central bank, it is clear that residents' confidence in future income and employment is at historic lows since 2013. The reduced expectations for employment and income can also explain the behavior of residents choosing to repay existing loans early and reduce debt.

1. Bank asset-liability perspective: With the adjustment of existing mortgage rates, deposit rates still need to decline.

From the perspective of banks, especially small and medium-sized banks, they are facing a situation where loan growth is insufficient and deposit costs are rising, which has collectively led to a continuous decline in net interest margins of banks.

1. Asset side: Since 2023, the proportion of interest income from loans for rural commercial banks and joint-stock banks has decreased. Banks represented by rural commercial banks have seen a significant decline in loan growth, from 10.34% in the first half of 2023 to 6.94% in the first half of 2024. Meanwhile, the loan growth of state-owned large banks remained higher than that of small and medium-sized banks during the same period

• A more obvious crowding-out effect is shown.

• Liabilities side: The cost of bank deposits represented by state-owned banks has significantly increased, showing a trend deviating from the downward adjustment of deposit rates. In recent years, it has become a trend to push down the cost of bank liabilities. Major banks are often the leaders in lowering deposit rates. Since 2022, there have been 4 rounds of deposit rate cuts. However, the cost of deposits has shown a trend of not decreasing but increasing.

• Net interest margin: Looking at the time series trend of bank net interest margins, both state-owned major banks and small to medium-sized banks have shown a significant decline. As of the second quarter of 2024, the net interest margins of rural commercial banks, joint-stock banks, and city commercial banks have dropped to historical lows of 1.72%, 1.63%, and 1.45%, respectively.

The reduction of existing mortgage rates helps alleviate the pressure on the bank's asset side, but from the perspective of net interest margin space, it needs to be accompanied by further downward adjustment of deposit rates. Early repayment of loans accelerates the reduction of banks' high-quality, high-interest assets, while the adjustment of existing mortgage rates directly reduces the yield of banks' high-interest assets. From the bank's perspective, it is all about losses and interest margin contraction. Therefore, the "constraint on bond market due to the cost of bank liabilities" is a static logic. The dynamic logic is that loan rates need to follow a "left foot stepping on the right foot" approach. If loan rates are lowered by 25-50 basis points under relatively rigid liability costs, the average net interest margin of banks may be compressed to the range of [1.1%, 1.4%]. Therefore, we believe that from the perspective of policy expectations to alleviate bank pressure, after the reduction of existing mortgage rates, deposit rates still need to decline.

In terms of specific impact effects, if existing mortgage rates are lowered, on the one hand, it may alleviate the asset-side pressure caused by early repayment, but on the other hand, it may further thin the bank's net interest margin. The comprehensive impact may depend on whether the cost of liabilities represented by deposit rates synchronously decreases.

• How do long-term bond rates and mortgage rates affect each other?

The inverted yield of residents' assets and liabilities may determine that there is still considerable room for a significant reduction in weighted mortgage rates. From the perspective of rational behavior of residents, the yield on the asset side must be higher than or at least equal to the cost on the liability side for residents to be willing to leverage. If the yields of the two sides are inverted, the most reasonable behavior is to not take any loans, reduce debt, and hedge risks. As the major part of the cost, the reduction of mortgage rates plays an important role in alleviating the inverted yield of residents' assets and liabilities, and the downward adjustment space of mortgage rates determined by fundamentals may still be significant.

• In terms of magnitude, the reduction of existing mortgage rates may be around 60-80 basis points. According to the 2024 China Regional Financial Operation Report, after the relaxation of real estate policies in August last year, over 23 trillion yuan of existing mortgage rates were reduced, with the adjusted weighted average rate at 4.27%, a decrease of 73 basis points. As of June 2024, the weighted average interest rate for individual housing loans of financial institutions was 3.45%. Taking this as a representative of incremental mortgage rates, there is still a compression space of 82 basis points between existing and incremental rates. On the other hand, looking at the disclosed data of listed banks on the medium to long-term loan yield, the current average level is around 4.17%, with a potential 70 basis points (BP) decrease to the current 3.45% loan rate level.

On the policy side, there is indeed room for a reduction in mortgage rates. In terms of real estate relaxation policies, a series of policies were introduced in August last year and May 17 this year. The political bureau meeting in April this year mentioned "taking into account the new changes in the supply and demand relationship of the real estate market... coordinating the research to digest the existing housing stock and optimize the policy measures for incremental housing." The political bureau meeting in July also proposed to "reserve early and introduce a batch of incremental policy measures in a timely manner," indicating a certain possibility of reducing existing mortgage rates in the future.

So, how will the reduction of existing mortgage rates affect bond market rates? From the perspective of boosting consumption, it may have a negative impact, but we believe that this effect may be relatively limited. It is more likely to be interpreted as positive from the perspective of the comparison between bank credit and bond logic:

1. ) Referring to the reduction range and interest rate performance last year: The relaxation of real estate policies in August led to a decrease in mortgage rates in first-tier cities, driving up bond market rates. The rebound range from late August to early September was within 10 basis points (BP). The rate adjustment brought by the real estate relaxation policy on May 17 this year resulted in a more limited rate rebound. In terms of effect, according to the Q4 23 monetary policy report, a 73 BP reduction corresponds to a reduction of borrower interest expenses by 170 billion yuan per year. Without considering other factors, if the reduction range reaches 80 BP, the 38 trillion yuan mortgage may save around 300 billion yuan in interest expenses, but compared to last year's 70 trillion yuan final consumption expenditure, it may have a limited impact on economic growth.

2. ) From the perspective of credit-bond comparison logic: Currently, although long-term interest rates are at historical lows, the cost-effectiveness compared to loans is still higher. By calculating the level of asset EVA, the 30-year national bond is at 2.31%, higher than the mortgage loan at 1.93%, indicating that national bonds have a relatively better cost-effectiveness compared to credit. If mortgage rates decrease, the cost-effectiveness of long-term bonds will be further highlighted. In terms of trend, the decline in loan rates may precede a significant decline in bond rates. Therefore, an 80 BP reduction in mortgage rates may correspond to a decrease of around 20 BP in the 30-year national bond yield in the medium to long term.

Based on the above logic, how should we understand the central bank's persistence in controlling long-term bond rates? We may consider controlling the speed of the decline in long-term bond rates, the monetary coordination of policy adjustments for existing mortgage rates, and the supportive monetary policy for the economy as three orthogonal events to understand bond trading

1. Risk Warning

The central bank's unexpected tightening of monetary policy, large-scale return of wealth management products triggering market fluctuations, and significant convergence of institutional behaviors forming positive and negative feedback loops.

Source: Debon Fixed Income Original Title "In-depth Framework: 30-year Mortgage and 30-year Treasury Bonds" Author: Lv Pin Qualification Number: S0120524050005 Research Assistant Yan Lingyi