TERM STRUCTURE OF INTEREST RATES

 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,
 It plays a crucial role in identifying the current state of an economy.
 It reflects the expectations of market participants about future changes in interest rates and
their assessment of monetary policy conditions

When you invest your money into interest-bearing security, the amount of interest paid will
vary depending on the length of the investment term. In other words, a savings bond with a
one year term may pay a fairly low interest rate, but if you invest your money in a bond with a
ten-year term, you may receive a higher rate of interest. When we discuss how the length of
investment affects a security’s interest rate, we are talking about the security’s term structure.
What Is the Term Structure of Interest Rates?

The term structure of interest rates is a comparison tool that plots the term length of
investment securities against the amount of interest they pay. In economic circles, the term
structure of interest rates is frequently referred to as a yield curve.

What Is the Yield Curve?

The yield curve is a line that represents the yield (or amount of interest paid) by various bonds
and investment notes that achieve maturity at varying dates.

How Does the Yield Curve Behave?

The yield curve most commonly analyzed by market analysts compares the interest rates paid
by five types of U.S. Treasury debt: the three-month, two-year, five-year, 10-year and 30-year
notes

 In a normal yield curve, the yield paid by bonds increases with length. Therefore, a
30-year bond pays more than a 10-year bond, which pays more than a five-year bond,
which pays more than a two-year bond, which pays more than a three-month bond.
Typically the yield rapidly leaps from a three-month bond to a five-year bond. The
curve flattens out a bit from there, but in normal conditions, long-term yields will still
be higher than short-term yields.
 In an inverted yield curve, the bond market’s short-term rates are higher than its long-
term rates. That means, for instance, that a two-year treasury note will offer a higher
yield than a five-year note. Under normal conditions, however, the longer-term bond
would produce a higher yield. A yield curve inversion and the bond rates that come
along with it can upend the bond market and may portend worse economic conditions
to come.
 A flat yield curve falls between a normal and an inverted yield curve. When market
conditions cause yield curves to change from normal to inverted, or vice versa, they
pass through a transitional period where nearly all the bond terms produce roughly the
same yield. If the economy is transitioning from growth to contraction, the long-term
yields will fall and the short-term yields will rise, creating this flattening effect en
route to an eventual yield curve inversion. But eventually, the economy will return to
growth and bond yields will return to normal conditions, passing through another flat
yield curve along the way.

How to Interpret the Yield Curve

When the treasury yield curve is normal, it indicates investor confidence in future economic
growth. However, this does not mean that savvy investors rush off to park their money in the
longest-term bonds, even though they offer the highest interest rates.

 In a normal yield curve, there often isn’t a massive difference in the long-term yields
offered by a 30-year bond versus the yields offered by a 5-year bond. Therefore, many
investors will opt for the shorter-term 5-year bond, reclaim their money at the end of
those five years, and look for something new to invest in, such as stocks or real estate
or new treasury notes. Yet some people stay out of the bond market entirely during a
normal yield curve, because while bonds pay decently in a growing economy, stocks
tend to pay even more.
 When the yield curve inverts, it means that investors and economists are pessimistic
about long-term economic growth. The advantage to bond investing, however, is that
you get locked into an interest rate when you purchase debt security—which is a good
 thing if the economy is trending downward. Therefore, in the early days of a yield
curve inversion, many investors will try to buy up long term bonds before they
decrease further in value. While they aren’t acquiring those bonds at their peak rate,
they are nonetheless guaranteed some degree of economic certainty since the long-
term bonds will pay their promised interest rates, even if overall economic activity
declines further.

The term of the structure of interest rates has three primary shapes.

1. Upward sloping—long-term yields are higher than short-term yields. This is considered
to be the "normal" slope of the yield curve and signals that the economy is in an
expansionary mode.
2. Downward sloping—short-term yields are higher than long-term yields. Dubbed as an
"inverted" yield curve and signifies that the economy is in, or about to enter, a recessive
period.
3. Flat—very little variation between short and long-term yields. This signals that the
market is unsure about the future direction of the economy.

Investors who are able to predict how the term structure of interest rates shift can invest
accordingly and take advantage of the corresponding changes in bond prices.

Normal Yield Curve

If short-term yields are lower than long-term yields, the curve slopes upwards and is called a
positive or normal yield curve:
In general, when the term structure of interest rates curve is positive, it indicates that investors
desire a higher rate of return for taking an increased risk of lending their money over a longer
period of time.

Many economists believe that a steep positive curve means that investors expect strong future
economic growth with higher future inflation (and thus higher interest rates).

Inverted Yield Curve

If short-term yields are higher than long-term yields, the curve slopes downwards and is called a
negative or inverted yield curve:
A sharply inverted curve means that investors expect sluggish economic growth with lower
future inflation (and thus lower interest rates). 

Why Is the Term Structure of Interest Rates Important?

Because the term structure of interest rates is generally indicative of future interest rates (which
are indicative of an economy's expansion or contraction), changes in the yield curve can provide
a great deal of information. 

In the 1990s, Duke Professor Campbell Harvey found that inverted yield curves have preceded
the last five US recessions.

Changes in these curves can also have an impact on portfolio returns by making certain bonds
more or less valuable compared to other bonds.
Flat Term Structure

A flat yield curve exists when there is little-to-no variation between short- and long-term yield
rates:

A flat curve generally indicates that investors are unsure about future economic growth and
inflation

Term Structure Theories

Any study of the term structure is incomplete without its background theories. They are pertinent
in understanding why and how are the yield curves so shaped.

#1 – The Expectations Theory/Pure Expectations Theory

Expectations theory states that current long-term rates can be used to predict short term rates of
future. It simplifies the return of one bond as a combination of the return of other bonds. For e.g.,
a 3-year bond would yield approximately the same return as three 1-year bonds.

#2 – Liquidity Preference Theory

This theory perfects the more commonly accepted understanding of liquidity preferences of
investors. Investors have a general bias towards short-term securities, which have higher
 liquidity as compared to the long-term securities, which get one’s money tied up for a long. Key
points of this theory are:

 The price change for long term debt security is more than that for a short term debt
security.
 Liquidity restrictions on long term bonds prevent the investor from selling it whenever he
wants.
 The investor requires an incentive to compensate for the various risks he is exposed to,
primarily price risk and liquidity risk.
 Less liquidity leads to an increase in yields, while more liquidity leads to falling yields,
thus defining the shape of upward and downward slope curves.

#3 – Market Segmentation Theory/Segmentation Theory

This theory is related to the supply-demand dynamics of a market. The yield curve shape is
governed by the following aspects:

 Preferences of investors for short term and long term securities.

 An investor tries to match the maturities of his’ assets and liabilities. Any mismatch can
lead to capital loss or income loss.
 Securities with varying maturities form a number of different supply and demand
curves, which then eventually inspire the final yield curve.
 Low supply and high demand lead to an increase in interest rates.

#4 – Preferred Habitat Theory

This theory states that investor preferences can be flexible, depending on their risk
tolerance level. They can choose to invest in bonds outside their general preference also if they
are appropriately compensated for their risk exposure.
These were some of the main theories dictating the shape of a yield curve, but this list is not
exhaustive. Theories like Keynesian economic theory and substitutability theory have also been
proposed.

Advantages

 Indicator of the overall health of the economy – An upward sloping and steep curve
indicates good economic health while inverted, flat, and humped curves indicated a slowdown.
 Knowing how interest rates might change in the future, investors are able to make
informed decisions.
 It also serves as an indicator of inflation.
 Financial organizations have a heavy dependency on the term structure of interest rates
since it helps in determining rates of lending and savings.
 Yield curves give an idea of how overpriced or under-priced the debt securities may be.
 Disadvantages

 Yield curve risk – Investors who hold securities with yields depending on market interest
rates are exposed to yield curve risk to hedge against which they need to form well-differentiated
portfolios.
 Maturity matching to hedge against yield curve risk is not a straightforward task and
might not give the desired end results.

Limitations

The term structure of interest rates eventually is only a predicted estimation that might not
always be accurate, but it has hardly ever fallen out of place.

Conclusion

The term structure of interest rates is one of the most potent predictors of economic wellbeing.
All recessions in the past have been linked to inverted yield curves, showing how important a
role they play in the credit market. Yield curves aren’t ever constant. They keep changing,
reflecting the current market mood, helping the investors and financial intermediaries stay on top
of everything.

Economists and financial analysts employ term structure analysis, which frequently involves
creating or using mathematical models, for a variety of applications. Some of the most common
include

 forecasting future interest rates

 estimating the cost of capital for discounting future cash flows
 building predictive models of general economic growth (e.g., to project gross domestic
product)
 formulating monetary policy
 estimating future inflation
 understanding dynamics in financial markets
 constructing a portfolio or hedging strategy