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 curve.” 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:
#1 – Normal/Positive Yield
The normal yield curve has a positive slope. This stands true for securities with longer maturities that have greater risk exposure 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 yields 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 curve 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 curve is an important indicator of the imminent economic slowdown.
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#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 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.
- 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.
- 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.
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.
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.
This has been a guide to Term Structure. Here we discuss the top 5 types of term structure along with its theories, advantages, disadvantages, and limitations. Here are the other articles in fixed income that you may like –