Term Structure of Interest Rate (Definition, Theories)

What is the Term Structure of Interest Rate?

The term structure of interest rate can be defined as the graphical representation that depicts the relationship between interest rates (or yields on a bond) and a range of different maturities. The graph itself is called a “yield curveYield Curve The Yield Curve Slope is used to estimate the interest rates and changes in economic activities. It is a plot of bond yields of a particular issuer on the vertical axis (Y-axis) against various tenors/maturities on the horizontal axis (X-axis).read more.” The term structure of interest rates plays an important part in any economy by predicting the future trajectory of rates and facilitating quick comparison of yields based on time.

Types of Term Structure of Interest Rates

Primarily, the term structure of interest rates can take the following forms:

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For eg:
Source: Term Structure (wallstreetmojo.com)

#1 – Normal/Positive Yield

The normal yield curve has a positive slope. This stands true for securities with longer maturities that have greater risk exposureRisk Exposure Risk Exposure refers to predicting possible future loss incurred due to a particular business activity or event. You can calculate it by, Risk Exposure = Event Occurrence Probability x Potential Lossread more as opposed to short term securities. So rationally, an investor would expect higher compensation (yield), thus giving rise to a normal positively sloped yield curve.

Bond yieldsBond Yields The bond yield formula evaluates the returns from investment in a given bond. It is calculated as the percentage of the annual coupon payment to the bond price. The annual coupon payment is depicted by multiplying the bond's face value with the coupon rate.read more or interest rates are plotted against X-axis while time horizons are plotted on Y-Axis.

#2 – Steep

The steep yield curve is just another variation of the normal yield curveVariation Of The Normal Yield Curve A normal yield curve refers to a positive yield curve formed when the long-term debt instruments provide greater returns when compared to the short-term debt instruments when both these options possess equivalent credit risk and quality.read more just that a rise in interest rates occurs at a faster for long-maturity securities than the ones with a short maturity.

#3 – Inverted/Negative Yield

An inverted curve forms when there is a high expectation of long-maturity yields falling below short maturity yields in the future. An inverted yield curveInverted Yield Curve The inverted Yield curve is a rare graph that depicts future financial disasters by demonstrating how long-term debt instruments will yield lower returns than short-term debt instruments. The great financial crisis of 2007 is a good example of it. read more is an important indicator of the imminent economic slowdown.

#4 – Humped/Bell-Shaped

This type of curve is atypical and very infrequent. It indicated that yields for medium-term maturity are higher than both long and short terms, eventually suggesting a slowdown.

#5 – Flat

A Flat curve indicates similar returns for long-term, medium-term, and short-term maturities.

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 theoryExpectations Theory Expectations theory attempts to forecast short term interest rates based on current long-term rates by assuming no arbitrage opportunity. Therefore, implying that two investment strategies spread in a similar time horizon should yield an equal amount of returns.read more 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 preferencesLiquidity Preferences Liquidation preference is a clause that states the order of payment from the realization of assets in case of liquidation. It usually protects secured debt, trade creditors, other liabilities, and then preference and equity share holders.read more 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 riskLiquidity Risk Liquidity risk refers to 'Cash Crunch' for a temporary or short-term period and such situations are generally detrimental to any business or profit-making organization. Consequently, the business house ends up with negative working capital in most of the cases.read more.
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 lossCapital Loss Capital Loss is a loss when the value of the consideration received from the result of the transfer of capital assets is less than the aggregate value of the cost of acquisition & cost of the improvement. In simpler words, it can be stated as the loss derived from the transfer of capital assets.read more or income loss.
Securities with varying maturities form a number of different supply and demand curvesDemand Curves Demand Curve is a graphical representation of the relationship between the prices of goods and demand quantity and is usually inversely proportionate. That means higher the price, lower the demand. It determines the law of demand i.e. as the price increases, demand decreases keeping all other things equal.read more, 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 toleranceRisk Tolerance Risk tolerance is the investors' potential and willingness to bear the uncertainties associated with their investment portfolios. It is influenced by multiple individual constraints like the investor's age, income, investment objective, responsibilities and financial condition.read more 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.

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Term Structure

What is the Term Structure of Interest Rate?