Term structure of interest rates

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.

The term structure of interest rates, commonly known as the yield curve, depicts the interest rates of similar quality bonds at different maturities.

Essentially, 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 crucial role in identifying the current state of an economy. The term structure of interest rates reflects the expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions.

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

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.

Flat: Very little variation between short and long-term yields. This signals that the market is unsure about the future direction of the economy.

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.

Interest rates are both a barometer of the economy and an instrument for its control. The term structure of interest rates market interest rates at various maturities is a vital input into the valuation of many financial products. The goal of this reading is to explain the term structure and interest rate dynamics that is, the process by which the yields and prices of bonds evolve over time.

A spot interest rate (in this reading, “spot rate”) is a rate of interest on a security that makes a single payment at a future point in time. The forward rate is the rate of interest set today for a single-payment security to be issued at a future date. Section 2 explains the relationship between these two types of interest rates and why forward rates matter to active bond portfolio managers. Section 2 also briefly covers other important return concepts.

The swap rate curve is the name given to the swap market’s equivalent of the yield curve. Section 3 describes in more detail the swap rate curve and a related concept, the swap spread, and explains their use in valuation.

Sections 4 and 5 describe traditional and modern theories of the term structure of interest rates, respectively. Traditional theories present various largely qualitative perspectives on economic forces that may affect the shape of the term structure. Modern theories model the term structure with greater rigor.

Section 6 describes yield curve factor models. The focus is a popular three-factor term structure model in which the yield curve changes are described in terms of three independent movements: level, steepness, and curvature. These factors can be extracted from the variance covariance matrix of historical interest rate movements.

Types:

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.

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.

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.

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.

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.

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:

• Liquidity restrictions on long term bonds prevent the investor from selling it whenever he wants.
• The price change for long term debt security is more than that for a short term debt security.
• 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.
• The investor requires an incentive to compensate for the various risks he is exposed to, primarily price risk and liquidity risk.

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.

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.

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:

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

Advantages

• Knowing how interest rates might change in the future, investors are able to make informed decisions.
• 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.
• Financial organizations have a heavy dependency on the term structure of interest rates since it helps in determining rates of lending and savings.
• It also serves as an indicator of inflation.
• Yield curves give an idea of how overpriced or under-priced the debt securities may be.