Theory of the Term Structure of Interest Rates

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The term structure of interest rates is the relationship of market interest rates and terms to the maturity of various fixed rate securities. The yield curve is a graphical representation of this relationship. There are two main theories that describe the shape of the yield curve: expectations and segmentation theory.

Expectations Theory

The expectations theory states that market participants' expectations for the future direction of interest rates determine the shape of the yield curve. For example, a corporation may decide to issue long-term bonds now if it believes there will be a meaningful rise in interest rates. By borrowing now, it is locking in the lower prevailing rates. Likewise, individuals looking to purchase homes may decide to try to obtain a mortgage at current rates.

Segmentation Theory

The segmentation theory suggests that the shape of the yield curve is driven by various market participants' preferences for various terms to maturity. Therefore, the pricing of short-term and long-term fixed rate securities is segmented based on market participants' preferences. For example, short-term bond investors will only invest in short-term securities.

Normal Yield Curve

In general, the yield curve is upward-sloping. This is referred to as a normal yield curve. In essence, an upward-sloping yield curve means that the yield on short-term securities is lower than the yield on long-term fixed rate securities as long-term bond investors expect to be compensated for inflation risk over a longer holding period. The wider the gap between short- and long-term securities, the steeper the yield curve.

Inverted Yield Curve

A parallel shift in the yield curve occurs when changes in yields are the same for all bonds. A twist of the yield curve happens when interest rates change unevenly for bonds with the same terms to maturity. In these instances, the yield curve is still upward-sloping. An inverted yield curve (or negative yield curve) is when the yield of short-term securities is higher than long-term securities. An inverted yield curve is rare and occurs when investors have little confidence in the future of the economy.

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