The Term Structure of Interest Rates

The Term Structure of Interest Rates

The term structure of interest rates refers to the
relationship between time to maturity and
yields for a particular category of bonds at a
particular point in time.

Uses of Term Structure

1.

2.
3.
4.
5.
6.

Analyzing the returns of asset commitments for

different terms.
Assessing consensus expectations of future
interest rates.
Pricing bonds and other fixed-payment contracts.
Pricing contingent claims on fixed income
securities.
Arbitraging between bonds of different maturities
Forming expectations about the economy.

Yield Curve
The term structure is usually plotted in the
form of a yield curve, which is a graphical
depiction of the relationship between yields
and time for bonds that are identical except for
maturity.

Yield Curve
The yield curve is normally upward sloping, meaning that
interest rates rise with maturity.
Upward sloping curves can have various degrees of steepness.
When short-term rates become higher than long-term rates,
the yield curve slopes downward and are called an inverted
yield curve.
Such yield curves almost always precede a recession.

Yield Curve

Spot and Short Rates

Spot Rate
It is the yield on a zero-coupon bond of a
certain maturity, e.g., a one-year zero, a two
year zero and so on.
Short Rate
It is the interest rate for a given time interval
(e.g. a year) at a given point of time.

Spot and Short Rates

A two-year spot rate is the geometric
average of todays short rate and the next
years short rate.
If Y2 represents the two-year spot rate and r1,
r2 are the two short rates, then:

Yield on a long-term bond reflects the path of

short rates anticipated by the market over
the life of the bond.

Forward Interest Rate

Future short rates can be inferred from the
yield curve of zero-coupon bonds.

Because
future
interest
rates
are
uncertain, the future short interest rate is
often called the forward interest rate.

Example Spot Rates and Short

Rates
The yield to maturity on zero-coupon bonds of maturity from 1year
to 4 years is given below:
Maturity (years)
1
5
2
6
3
7
4
8

YTM (%)

The short rate for year 2 = [(1.06)2/1.05]-1

= 0.0701 or 7.01%

The short rate for year 3 = [(1.07)3/ (1.06)2]-1 = 0.09025 or

9.025%
The short rate for year 4 = [(1.08)4/(1.07)3]-1 = 0.1106 or 11.06%

Valuing Coupon Bonds

The yield curve for zero-coupon bonds can be used to value coupon
bonds of different maturities.
The yield to maturity on zero-coupon bonds of maturity from 1year
to 4
years is given below:
Maturity (years)

YTM (%)

1
5
2
6
3
7
4
8
The value of a 10% coupon bond with a maturity of 3 years and
making
annual coupon payments will be

Term Structure Theories

A theory of term structure of interest rates is
needed to explain the shape and slope of
the yield curve and why it shifts over time.
Two important term structure theories are:
The Expectations Theory
The Liquidity Premium Theory

Expectations Theory
The yields on long-term bonds
geometric averages of present
expected future short rates.

are
and

Except expectations about future interest

rates, there are no other factors that
determine the term structure.
An investor gets the same holding period
return from bonds of different maturities.

Expectations Theory
An upward sloping curve means
expected short rates in future are
higher than the current short rates.
Similarly a flat yield curve is an
indication that short term interest
rates are likely to remain the same.
A downward sloping yield curve
indicates that short-term rates are
expected to decline.

Liquidity Preference Theory

Long-term bonds are more risky.
Investors will demand a premium for
the risk associated with long-term
bonds.
The yield curve has an upward bias
built into the long-term rates
because of the risk premium.

Liquidity Preference Theory

Forward rates contain both interest
rate expectations and a liquidity
premium and are not equal to
expected future short-term rates.
Liquidity
Preference
Theory
is
consistent with a variety of yield
curve shapes.

Liquidity Premiums and Yield Curves

Yields

Observed
Yield Curve

Forward Rates

Liquidity Premium
Maturit

Liquidity Premiums and Yield Curves

Yields

Observed Yield Curv

Forward Rates
Liquidity Premium
Maturity

Interpreting the Term Structure

If the yield curve reflects expectations of future short
rates, then it offers a potentially powerful tool for
fixed income investors.
They can use the term structure to infer the
expectations of other investors in the economy.
These expectations can then be used as a benchmark.
For example, if we are relatively more optimistic than
other investors that interest rates will fall, we will be
more willing to extend our portfolios into long-term
bonds.

Interpreting the Term Structure

Unfortunately, while the yield curve does reflect
expectations of future interest rates, it also reflects
other factors such as liquidity premium.
Therefore, it is difficult to draw conclusions from the
yield curve.
A rough approach to derive expected future short
rates assumes constant liquidity premiums, but this
approach has little to recommend.
Still, very steep yield curves are interpreted by
many professionals as warning signs of impending
rate increase.

Interpreting the Term Structure

The yield curve is a good predictor of business
cycle as a whole, because long-term rates tend to
rise in anticipation of an expansion of economic
capacity.
When the curve is steep, there is a far lower
probability of recession in the next year than
when it is inverted or falling.
For this reason, the yield curve is a component of
the index of leading indicators.