Term structure of Interest Rates

The term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. When graphed, the term structure of interest rates is known as a yield curve, and it plays a central role in an economy. The term structure reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

The term structure of interest rates, also called the yield curve, is a graph that plots the yields of similar-quality bonds against their maturities, from shortest to longest. 

How it works (Example):

The term structure of interest rates shows the various yields that are currently being offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term and long-term bonds.

Note that the chart does not plot coupon rates against a range of maturities that graph is called the spot curve.

The term structure of interest rates takes three primary shapes. If short-term yields are lower than long-term yields, the curve slopes upwards and the curve is called a positive (or “normal”) yield curve. Below is an example of a normal yield curve:

If short-term yields are higher than long-term yields, the curve slopes downwards and the curve is called a negative (or “inverted”) yield curve. Below is example of an inverted yield curve:

Finally, a flat term structure of interest rates exists when there is little or no variation between short and long-term yield rates. Below is an example of a flat yield curve:

It is important that only bonds of similar risk are plotted on the same yield curve. The most common type of yield curve plots Treasury securities because they are considered risk-free and are thus a benchmark for determining the yield on other types of debt.

The shape of the curve changes over time. Investors who are able to predict how term structure of interest rates will change can invest accordingly and take advantage of the corresponding changes in bond prices.

Why it Matters:

In general, when the term structure of interest rates curve is positive, this indicates that investors desire a higher rate of return for taking the increased risk of lending their money for a longer time period.

Many economists also believe that a steep positive curve means that investors expect strong future economic growth with higher future inflation (and thus higher interest rates), and that a sharply inverted curve means that investors expect sluggish economic growth with lower future inflation (and thus lower interest rates). A flat curve generally indicates that investors are unsure about future economic growth and inflation.

There are three central theories that attempt to explain why yield curves are shaped the way they are.

1. The “expectations theory” says that expectations of increasing short-term interest rates are what create a normal curve (and vice versa).
2. The “liquidity preference hypothesis” says that investors always prefer the higher liquidity of short-term debt and therefore any deviance from a normal curve will only prove to be a temporary phenomenon.
3. The “segmented market hypothesis” says that different investors adhere to specific maturity segments. This means that the term structure of interest rates is a reflection of prevailing investment policies.

Because the term structure of interest rates is generally indicative of future interest rates, which are indicative of an economy’s expansion or contraction, yield curves and changes in these curves can provide a great deal of information. In the 1990s, Duke University professor Campbell Harvey found that inverted yield curves have preceded the last five U.S. recessions.

Changes in the shape of the term structure of interest rates can also have an impact on portfolio returns by making some bonds relatively more or less valuable compared to other bonds. These concepts are part of what motivate analysts and investors to study the term structure of interest rates carefully.

Theories of the Term Structure of Interest Rates:

Various theories have been developed to explain the shape of the yield curve. These theories provide insights into the expectations of investors and market participants. Some prominent theories include:

• Expectations Theory: The expectations theory suggests that the shape of the yield curve reflects market expectations of future interest rates. According to this theory, long-term interest rates are an average of current and future short-term interest rates. If investors expect interest rates to remain unchanged, the yield curve will be flat. Conversely, if investors anticipate higher future interest rates, the yield curve will be upward sloping (normal yield curve), and if they expect lower future interest rates, the yield curve will be downward sloping (inverted yield curve).

• Segmented Markets Theory: The segmented markets theory posits that investors have specific preferences for certain maturities, leading to segmented markets for debt instruments. Under this theory, interest rates are determined by the supply and demand dynamics within each maturity segment. As a result, the shape of the yield curve is not necessarily related to market expectations or future interest rate movements but is influenced by the preferences of investors for specific maturities.

• Liquidity Preference Theory: The liquidity preference theory, proposed by John Maynard Keynes, suggests that investors demand higher yields to compensate for the illiquidity and risk associated with longer-term bonds. According to this theory, the yield curve is upward sloping due to the liquidity premium investors require for holding longer-term debt instruments.

• Market Segmentation Theory: The market segmentation theory argues that different investors have specific preferences and constraints based on their investment horizons and regulatory requirements. These preferences lead to distinct segments within the bond market, with different demand and supply dynamics for different maturities. Consequently, the shape of the yield curve is driven by the preferences and actions of market participants within each segment.

Construction of the Yield Curve:

The yield curve is constructed by plotting the yields or interest rates of debt instruments against their respective maturities. The process involves collecting market data on yields for various debt instruments with different maturities, such as Treasury bonds, corporate bonds, or interbank lending rates. The yields are then plotted on a graph, with maturities on the x-axis and yields on the y-axis. Connecting these data points creates the yield curve.

The yield curve can be constructed using two main methods:

1. Bootstrapping: Bootstrapping is a popular method for constructing the yield curve. It involves using the prices of existing bonds or other fixed-income securities to derive implied yields for different maturities. By iteratively calculating yields for various maturities and using them to price additional bonds, a full yield curve can be constructed.

2. Interpolation: Interpolation is another method used to construct the yield curve. It involves estimating yields for maturities that do not have direct market data available. Interpolation techniques, such as linear interpolation or cubic spline interpolation, are used to estimate yields between observed points on the yield curve.

Factors Influencing the Shape of the Yield Curve:

• Economic Conditions: Economic indicators, such as GDP growth, inflation rates, and unemployment levels, have a significant impact on the shape of the yield curve. Expectations of future economic conditions and inflation can influence investor sentiment and their willingness to demand different maturities. Positive economic conditions and expectations of future growth tend to result in an upward-sloping yield curve (normal yield curve), while economic uncertainties or expectations of a slowdown can lead to a downward-sloping yield curve (inverted yield curve).

• Monetary Policy: Central banks play a crucial role in shaping the yield curve through their monetary policy decisions. Changes in key interest rates, such as the benchmark lending rate or overnight rates, directly affect short-term interest rates and, subsequently, the yield curve. Central banks’ actions, such as interest rate hikes or cuts, can influence the yield curve’s slope and shape.

• Inflation Expectations: Expectations of future inflation impact the shape of the yield curve. If investors anticipate higher inflation in the future, they will demand higher yields on longer-term bonds to compensate for the erosion of purchasing power. Consequently, the yield curve may be upward sloping. Conversely, if inflation expectations are low, the yield curve may be flat or downward sloping.

• Supply and Demand Dynamics: The supply and demand for debt instruments at different maturities can affect the yield curve. If there is a higher demand for longer-term bonds compared to shorter-term bonds, their prices rise, and yields decrease, resulting in a downward sloping yield curve. Conversely, if there is more supply of longer-term bonds compared to shorter-term bonds, their prices may fall, and yields increase, leading to an upward sloping yield curve.

• Investor Sentiment and Risk Appetite: Investor sentiment and risk appetite play a role in shaping the yield curve. During periods of market uncertainty or heightened risk aversion, investors may prefer the safety of shorter-term bonds, leading to higher demand and lower yields. This preference can flatten or invert the yield curve. Conversely, during periods of optimism and risk-taking, investors may be more inclined to invest in longer-term bonds, leading to higher yields and a steeper yield curve.

Practical Applications of the Term Structure of Interest Rates:

The term structure of interest rates has several practical applications and implications:

• Yield Curve Analysis: Market participants analyze the yield curve to gain insights into interest rate expectations, market sentiment, and economic conditions. By examining the shape, slope, and changes in the yield curve over time, investors can make informed decisions about bond investments, fixed-income strategies, and asset allocation.

• Bond Valuation: The yield curve is an essential tool for valuing bonds. It provides a benchmark for determining the appropriate discount rate to calculate the present value of a bond’s cash flows. By matching the bond’s maturity to the corresponding yield on the yield curve, investors can estimate its fair value.

• Fixed-Income Investing: The term structure of interest rates helps fixed-income investors identify opportunities and manage risks. Investors can compare yields across different maturities to identify securities that offer attractive risk-adjusted returns. Additionally, the yield curve helps investors assess the risk and return trade-offs of various fixed-income strategies, such as yield curve positioning, duration management, and bond rolling strategies.

• Monetary Policy and Economic Indicators: Central banks closely monitor the yield curve to inform their monetary policy decisions. Changes in the yield curve shape and slope can provide insights into market expectations and economic conditions. Central banks may adjust key interest rates based on their interpretation of the yield curve and its implications for economic growth, inflation, and financial stability.