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Advanced Bond Concepts: Term Structure of Interest Rates

The term structure of interest rates, also known as the yield curve, is a very common bond
valuation method. Constructed by graphing the yield to maturities and the respective maturity
dates of benchmark fixed-income securities, the yield curve is a measure of the market's
expectations of future interest rates given the current market conditions. Treasuries, issued by
the federal government, are considered risk-free, and as such, their yields are often used as
the benchmarks for fixed-income securities with the same maturities. The term structure of
interest rates is graphed as though each coupon payment of a noncallable fixed-income
security were a zero-coupon bond that “matures” on the coupon payment date. The exact
shape of the curve can be different at any point in time. So if the normal yield curve changes
shape, it tells investors that they may need to change their outlook on the economy.

There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve: As its name indicates, this is the yield curve shape that forms
during normal market conditions, wherein investors generally believe that there will be no
significant changes in the economy, such as in inflation rates, and that the economy will
continue to grow at a normal rate. During such conditions, investors expect higher yields
for fixed income instruments with long-term maturities that occur farther into the future. In
other words, the market expects long-term fixed income securities to offer higher yields than
short-term fixed income securities. This is a normal expectation of the market because short-
term instruments generally hold less risk than long-term instruments; the farther into the
future the bond's maturity, the more time and, therefore, uncertainty the bondholder faces
before being paid back the principal. To invest in one instrument for a longer period of time,
an investor needs to be compensated for undertaking the additional risk.

Remember that as general current interest rates increase, the price of a bond will decrease and
its yield will increase.

2) Flat Yield Curve: These curves indicate that the market environment is sending mixed
signals to investors, who are interpreting interest rate movements in various ways. During
such an environment, it is difficult for the market to determine whether interest rates will
move significantly in either direction farther into the future. A flat yield curve usually occurs
when the market is making a transition that emits different but simultaneous indications of
what interest rates will do. In other words, there may be some signals that short-term interest
rates will rise and other signals that long-term interest rates will fall. This condition will
create a curve that is flatter than its normal positive slope. When the yield curve is flat,
investors can maximize their risk/return tradeoff by choosing fixed-income securities with the
least risk, or highest credit quality. In the rare instances wherein long-term interest rates
decline, a flat curve can sometimes lead to an inverted curve.

3) Inverted Yield Curve: These yield curves are rare, and they form during extraordinary
market conditions wherein the expectations of investors are completely the inverse of those
demonstrated by the normal yield curve. In such abnormal market environments, bonds with
maturity dates further into the future are expected to offer lower yields than bonds with
shorter maturities. The inverted yield curve indicates that the market currently expects
interest rates to decline as time moves farther into the future, which in turn means the market
expects yields of long-term bonds to decline. Remember, also, that as interest rates decrease,
bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income
investments when there is an inverted yield curve, which indicates that investors expect to
receive less compensation for taking on more risk. Some investors, however, interpret an
inverted curve as an indication that the economy will soon experience a slowdown, which
causes future interest rates to give even lower yields. Before a slowdown, it is better to lock
money into long-term investments at present prevailing yields, because future yields will be
even lower.
The Theoretical Spot Rate Curve
Unfortunately, the basic yield curve does not account for securities that have varying coupon
rates. When the yield to maturity was calculated, we assumed that the coupons were
reinvested at an interest rate equal to the coupon rate, therefore, the bond was priced at par as
though prevailing interest rates were equal to the bond's coupon rate.

The spot-rate curve addresses this assumption and accounts for the fact that many Treasuries
offer varying coupons and would therefore not accurately represent similar noncallable fixed-
income securities. If for instance you compared a 10-year bond paying a 7% coupon with a
10-year Treasury bond that currently has a coupon of 4%, your comparison wouldn't mean
much. Both of the bonds have the same term to maturity, but the 4% coupon of the Treasury
bond would not be an appropriate benchmark for the bond paying 7%. The spot-rate curve,
however, offers a more accurate measure as it adjusts the yield curve so it reflects any
variations in the interest rate of the plotted benchmark. The interest rate taken from the plot is
known as the spot rate.

The spot-rate curve is created by plotting the yields of zero-coupon Treasury bills and their
corresponding maturities. The spot rate given by each zero-coupon security and the spot-rate
curve are used together for determining the value of each zero-coupon component of a
noncallable fixed-income security. Remember, in this case, that the term structure of interest
rates is graphed as though each coupon payment of a noncallable fixed-income security were
a zero-coupon bond.
T-bills are issued by the government, but they do not have maturities greater than one year.
As a result, the bootstrapping method is used to fill in interest rates for zero-coupon securities
greater than one year. It is important to remember that the bootstrapping method equates a T-
bill's value to the value of all zero-coupon components that form the security.

The Credit Spread


The credit spread, or quality spread, is the additional yield an investor receives for acquiring
a corporate bond instead of a similar federal instrument. As illustrated in the graph below, the
spread is demonstrated as the yield curve of the corporate bond and is plotted with the term
structure of interest rates. Remember that the term structure of interest rates is a gauge of the
direction of interest rates and the general state of the economy. Corporate fixed-income
securities have more risk of default than federal securities and, as a result, the prices of
corporate securities are usually lower, while corporate bonds usually have a higher yield.

When inflation rates are increasing (or the economy is contracting) the credit spread between
corporate and Treasury securities widens. This is because investors must be offered
additional compensation (in the form of a higher coupon rate) for acquiring the higher risk
associated with corporate bonds.

When interest rates are declining (or the economy is expanding), the credit spread between
Federal and corporate fixed-income securities generally narrows. The lower interest rates
give companies an opportunity to borrow money at lower rates, which allows them to expand
their operations and also their cash flows. When interest rates are declining, the economy is
expanding in the long run, so the risk associated with investing in a long-term corporate bond
is also generally lower.

The yield curve is graphed using government securities, which are used as benchmarks for
fixed income investments. The yield curve, in conjunction with the credit spread, is used for
pricing corporate bonds.

What Does Term Structure Of Interest Rates Mean?


A yield curve displaying the relationship between spot rates of zero-coupon securities and
their term to maturity. The resulting curve allows an interest rate pattern to be determined,
which can then be used to discount cash flows appropriately. Unfortunately, most bonds carry
coupons, so the term structure must be determined using the prices of these securities. Term
structures are continuously changing, and though the resulting yield curve is usually normal,
it can also be flat or inverted.

Advanced Bond Concepts: Convexity

For any given bond, a graph of the relationship between price and yield is convex. This
means that the graph forms a curve rather than a straight-line (linear). The degree to which
the graph is curved shows how much a bond's yield changes in response to a change in price.
In this section we take a look at what affects convexity and how investors can use it to
compare bonds.

Convexity and Duration


If we graph a tangent at a particular price of the bond (touching a point on the curved price-
yield curve), the linear tangent is the bond's duration, which is shown in red on the graph
below. The exact point where the two lines touch represents Macaulay duration. Modified
duration must be used to measure how duration is affected by changes in interest rates. But
modified duration does not account for large changes in price. If we were to use duration to
estimate the price resulting from a significant change in yield, the estimation would be
inaccurate. The yellow portions of the graph show the ranges in which using duration for
estimating price would be inappropriate.

Furthermore, as yield moves further from Y*, the yellow space between the actual bond price
and the prices estimated by duration (tangent line) increases.
The convexity calculation, therefore, accounts for the inaccuracies of the linear duration line.
This calculation that plots the curved line uses a Taylor series, a very complicated calculus
theory that we won't be describing here. The main thing for you to remember about convexity
is that it shows how much a bond's yield changes in response to changes in price.

Properties of Convexity
Convexity is also useful for comparing bonds. If two bonds offer the same duration and yield
but one exhibits greater convexity, changes in interest rates will affect each bond differently.
A bond with greater convexity is less affected by interest rates than a bond with less
convexity. Also, bonds with greater convexity will have a higher price than bonds with a
lower convexity, regardless of whether interest rates rise or fall. This relationship is
illustrated in the following diagram:

As you can see Bond A has greater convexity than Bond B, but they both have the same price
and convexity when price equals *P and yield equals *Y. If interest rates change from this
point by a very small amount, then both bonds would have approximately the same price,
regardless of the convexity. When yield increases by a large amount, however, the prices of
both Bond A and Bond B decrease, but Bond B's price decreases more than Bond A's. Notice
how at **Y the price of Bond A remains higher, demonstrating that investors will have to pay
more money (accept a lower yield to maturity) for a bond with greater convexity.

What Factors Affect Convexity?


Here is a summary of the different kinds of convexities produced by different types of bonds:

1) The graph of the price-yield relationship for a plain vanilla bond exhibits positive
convexity. The price-yield curve will increase as yield decreases, and vice versa. Therefore,
as market yields decrease, the duration increases (and vice versa).

2) In general, the higher the coupon rate, the lower the convexity of a bond. Zero-coupon
bonds have the highest convexity.
3) Callable bonds will exhibit negative convexity at certain price-yield combinations.
Negative convexity means that as market yields decrease, duration decreases as well. See the
chart below for an example of a convexity diagram of callable bonds.

Remember that for callable bonds, modified duration can be used for an accurate estimate of
bond price when there is no chance that the bond will be called. In the chart above, the
callable bond will behave like an option-free bond at any point to the right of *Y. This
portion of the graph has positive convexity because, at yields greater than *Y, a company
would not call its bond issue: doing so would mean the company would have to reissue new
bonds at a higher interest rate. Remember that as bond yields increase, bond prices are
decreasing and thus interest rates are increasing. A bond issuer would find it most optimal, or
cost-effective, to call the bond when prevailing interest rates have declined below the callable
bond's interest (coupon) rate. For decreases in yields below *Y, the graph has negative
convexity, as there is a higher risk that the bond issuer will call the bond. As such, at yields
below *Y, the price of a callable bond won't rise as much as the price of a plain vanilla bond.

Convexity is the final major concept you need to know for gaining insight into the more
technical aspects of the bond market. Understanding even the most basic characteristics of
convexity allows the investor to better comprehend the way in which duration is best
measured and how changes in interest rates affect the prices of both plain vanilla and callable
bonds.
Yield curve
The US dollar yield curve as of 9 February 2005. The curve has a typical upward sloping
shape.

In finance, the yield curve is the relation between the interest rate (or cost of borrowing) and
the time to maturity of the debt for a given borrower in a given currency. For example, the
U.S. dollar interest rates paid on U.S. Treasury securities for various maturities are closely
watched by many traders, and are commonly plotted on a graph such as the one on the right
which is informally called "the yield curve." More formal mathematical descriptions of this
relation are often called the term structure of interest rates.

The yield of a debt instrument is the overall rate of return available on the investment. For
instance, a bank account that pays an interest rate of 4% per year has a 4% yield. In general
the percentage per year that can be earned is dependent on the length of time that the money
is invested. For example, a bank may offer a "savings rate" higher than the normal checking
account rate if the customer is prepared to leave money untouched for five years. Investing
for a period of time t gives a yield Y(t).

This function Y is called the yield curve, and it is often, but not always, an increasing function
of t. Yield curves are used by fixed income analysts, who analyze bonds and related
securities, to understand conditions in financial markets and to seek trading opportunities.
Economists use the curves to understand economic conditions.

The typical shape of the yield curve

The British pound yield curve as of 9 February 2005. This curve is unusual in that long-term
rates are lower than short-term ones.

Yield curves are usually upward sloping asymptotically: the longer the maturity, the higher
the yield, with diminishing marginal increases (that is, as one moves to the right, the curve
flattens out). There are two common explanations for upward sloping yield curves. First, it
may be that the market is anticipating a rise in the risk-free rate. If investors hold off
investing now, they may receive a better rate in the future. Therefore, under the arbitrage
pricing theory, investors who are willing to lock their money in now need to be compensated
for the anticipated rise in rates—thus the higher interest rate on long-term investments.

However, interest rates can fall just as they can rise. Another explanation is that longer
maturities entail greater risks for the investor (i.e. the lender). A risk premium is needed by
the market, since at longer durations there is more uncertainty and a greater chance of
catastrophic events that impact the investment. This explanation depends on the notion that
the economy faces more uncertainties in the distant future than in the near term. This effect is
referred to as the liquidity spread. If the market expects more volatility in the future, even if
interest rates are anticipated to decline, the increase in the risk premium can influence the
spread and cause an increasing yield.

The opposite position (short-term interest rates higher than long-term) can also occur. For
instance, in November 2004, the yield curve for UK Government bonds was partially
inverted. The yield for the 10 year bond stood at 4.68%, but was only 4.45% for the 30 year
bond. The market's anticipation of falling interest rates causes such incidents. Negative
liquidity premiums can exist if long-term investors dominate the market, but the prevailing
view is that a positive liquidity premium dominates, so only the anticipation of falling interest
rates will cause an inverted yield curve. Strongly inverted yield curves have historically
preceded economic depressions.

The shape of the yield curve is influenced by supply and demand: for instance if there is a
large demand for long bonds, for instance from pension funds to match their fixed liabilities
to pensioners, and not enough bonds in existence to meet this demand, then the yields on long
bonds can be expected to be low, irrespective of market participants' views about future
events.

The yield curve may also be flat or hump-shaped, due to anticipated interest rates being
steady, or short-term volatility outweighing long-term volatility.

Yield curves continually move all the time that the markets are open, reflecting the market's
reaction to news. A further "stylized fact" is that yield curves tend to move in parallel (i.e.,
the yield curve shifts up and down as interest rate levels rise and fall).

Types of yield curve

There is no single yield curve describing the cost of money for everybody. The most
important factor in determining a yield curve is the currency in which the securities are
denominated. The economic position of the countries and companies using each currency is a
primary factor in determining the yield curve. Different institutions borrow money at
different rates, depending on their creditworthiness. The yield curves corresponding to the
bonds issued by governments in their own currency are called the government bond yield
curve (government curve). Banks with high credit ratings (Aa/AA or above) borrow money
from each other at the LIBOR rates. These yield curves are typically a little higher than
government curves. They are the most important and widely used in the financial markets,
and are known variously as the LIBOR curve or the swap curve. The construction of the swap
curve is described below.

Besides the government curve and the LIBOR curve, there are corporate (company) curves.
These are constructed from the yields of bonds issued by corporations. Since corporations
have less creditworthiness than most governments and most large banks, these yields are
typically higher. Corporate yield curves are often quoted in terms of a "credit spread" over
the relevant swap curve. For instance the five-year yield curve point for Vodafone might be
quoted as LIBOR +0.25%, where 0.25% (often written as 25 basis points or 25bps) is the
credit spread.

Normal yield curve


From the post-Great Depression era to the present, the yield curve has usually been "normal"
meaning that yields rise as maturity lengthens (i.e., the slope of the yield curve is positive).
This positive slope reflects investor expectations for the economy to grow in the future and,
importantly, for this growth to be associated with a greater expectation that inflation will rise
in the future rather than fall. This expectation of higher inflation leads to expectations that the
central bank will tighten monetary policy by raising short term interest rates in the future to
slow economic growth and dampen inflationary pressure. It also creates a need for a risk
premium associated with the uncertainty about the future rate of inflation and the risk this
poses to the future value of cash flows. Investors price these risks into the yield curve by
demanding higher yields for maturities further into the future.

However, a positively sloped yield curve has not always been the norm. Through much of the
19th century and early 20th century the US economy experienced trend growth with
persistent deflation, not inflation. During this period the yield curve was typically inverted,
reflecting the fact that deflation made current cash flows less valuable than future cash flows.
During this period of persistent deflation, a 'normal' yield curve was negatively sloped.

Steep yield curve

Historically, the 20-year Treasury bond yield has averaged approximately two percentage
points above that of three-month Treasury bills. In situations when this gap increases (e.g. 20-
year Treasury yield rises higher than the three-month Treasury yield), the economy is
expected to improve quickly in the future. This type of curve can be seen at the beginning of
an economic expansion (or after the end of a recession). Here, economic stagnation will have
depressed short-term interest rates; however, rates begin to rise once the demand for capital is
re-established by growing economic activity.

In January 2010, the gap between yields on two-year Treasury notes and 10-year notes
widened to 2.90 percentage points, its highest ever.

Flat or humped yield curve

A flat yield curve is observed when all maturities have similar yields, whereas a humped
curve results when short-term and long-term yields are equal and medium-term yields are
higher than those of the short-term and long-term. A flat curve sends signals of uncertainty in
the economy. This mixed signal can revert to a normal curve or could later result into an
inverted curve. It cannot be explained by the Segmented Market theory discussed below.

Inverted yield curve

An inverted yield curve occurs when long-term yields fall below short-term yields. Under
unusual circumstances, long-term investors will settle for lower yields now if they think the
economy will slow or even decline in the future. An inverted curve has indicated a worsening
economic situation in the future 6 out of 7 times since 1970. The New York Federal Reserve
regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead. In
addition to potentially signaling an economic decline, inverted yield curves also imply that
the market believes inflation will remain low. This is because, even if there is a recession, a
low bond yield will still be offset by low inflation. However, technical factors, such as a
flight to quality or global economic or currency situations, may cause an increase in demand
for bonds on the long end of the yield curve, causing long-term rates to fall.
Theory

There are four main economic theories attempting to explain how yields vary with maturity.
Two of the theories are extreme positions, while the third attempts to find a middle ground
between the former two.

Market expectations (pure expectations) hypothesis

This hypothesis assumes that the various maturities are perfect substitutes and suggests that
the shape of the yield curve depends on market participants' expectations of future interest
rates. These expected rates, along with an assumption that arbitrage opportunities will be
minimal, is enough information to construct a complete yield curve. For example, if investors
have an expectation of what 1-year interest rates will be next year, the 2-year interest rate can
be calculated as the compounding of this year's interest rate by next year's interest rate. More
generally, rates on a long-term instrument are equal to the geometric mean of the yield on a
series of short-term instruments. This theory perfectly explains the observation that yields
usually move together. However, it fails to explain the persistence in the shape of the yield
curve.

Shortcomings of expectations theory: Neglects the risks inherent in investing in bonds


(because forward rates are not perfect predictors of future rates). 1) Interest rate risk 2)
Reinvestment rate risk

Liquidity preference theory

The Liquidity Preference Theory, also known as the Liquidity Premium Theory, is an
offshoot of the Pure Expectations Theory. The Liquidity Preference Theory asserts that long-
term interest rates not only reflect investors’ assumptions about future interest rates but also
include a premium for holding long-term bonds (investors prefer short term bonds to long
term bonds), called the term premium or the liquidity premium. This premium compensates
investors for the added risk of having their money tied up for a longer period, including the
greater price uncertainty. Because of the term premium, long-term bond yields tend to be
higher than short-term yields, and the yield curve slopes upward. Long term yields are also
higher not just because of the liquidity premium, but also because of the risk premium added
by the risk of default from holding a security over the long term. The market expectations
hypothesis is combined with the liquidity preference theory:

Where rpn is the risk premium associated with an n year bond.

Market segmentation theory

This theory is also called the segmented market hypothesis. In this theory, financial
instruments of different terms are not substitutable. As a result, the supply and demand in the
markets for short-term and long-term instruments is determined largely independently.
Prospective investors decide in advance whether they need short-term or long-term
instruments. If investors prefer their portfolio to be liquid, they will prefer short-term
instruments to long-term instruments. Therefore, the market for short-term instruments will
receive a higher demand. Higher demand for the instrument implies higher prices and lower
yield. This explains the stylized fact that short-term yields are usually lower than long-term
yields. This theory explains the predominance of the normal yield curve shape. However,
because the supply and demand of the two markets are independent, this theory fails to
explain the observed fact that yields tend to move together (i.e., upward and downward shifts
in the curve).

For a brief period in the last week of 2005, and again in early 2006, the US Dollar yield curve
inverted, with short-term yields actually exceeding long-term yields. Market segmentation
theory would attribute this to an investor preference for longer term securities, particularly
from pension funds and foreign investors who prefer guaranteed longer term yields.

Preferred habitat theory

The Preferred Habitat Theory is another guise of the Market Segmentation theory, and states
that in addition to interest rate expectations, investors have distinct investment horizons and
require a meaningful premium to buy bonds with maturities outside their "preferred"
maturity, or habitat. Proponents of this theory believe that short-term investors are more
prevalent in the fixed-income market, and therefore longer-term rates tend to be higher than
short-term rates, for the most part, but short-term rates can be higher than long-term rates
occasionally. This theory is consistent with both the persistence of the normal yield curve
shape and the tendency of the yield curve to shift up and down while retaining its shape.

Historical development of yield curve theory

On 15 August 1971, U.S. President Richard Nixon announced that the U.S. dollar would no
longer be based on the gold standard, thereby ending the Bretton Woods system and initiating
the era of floating exchange rates.

Floating exchange rates made life more complicated for bond traders, including importantly
those at Salomon Brothers in New York. By the middle of the 1970s, encouraged by the head
of bond research at Salomon, Marty Liebowitz, traders began thinking about bond yields in
new ways. Rather than think of each maturity (a ten year bond, a five year, etc.) as a separate
marketplace, they began drawing a curve through all their yields. The bit nearest the present
time became known as the short end—yields of bonds further out became, naturally, the long
end.

Construction of the full yield curve from market data


Typical inputs to the money market curve
Type Settlement date Rate (%)
Cash Overnight rate 5.58675

The usual Cash Tomorrow next rate 5.59375


representation
Cash 1m 5.625
of the yield
curve is a Cash 3m 5.71875
function P,
defined on all Future Dec-97 5.76
future times t, Future Mar-98 5.77
such that P(t)
represents the Future Jun-98 5.82
value today of
receiving one Future Sep-98 5.88
unit of currency Future Dec-98 6.00
t years in the
future. If P is Swap 2y 6.01253
defined for all
Swap 3y 6.10823
future t then we
can easily Swap 4y 6.16
recover the
yield (i.e. the Swap 5y 6.22
annualized Swap 7y 6.32
interest rate) for
borrowing Swap 10y 6.42
money for that
period of time Swap 15y 6.56
via the formula. Swap 20y 6.56
Swap 30y 6.56
A list of standard instruments used to build a money market yield curve.
The data is for lending in US dollar, taken from 6 October 1997

The significant difficulty in defining a yield curve therefore is to determine the function P(t).
P is called the discount factor function.

Yield curves are built from either prices available in the bond market or the money market.
Whilst the yield curves built from the bond market use prices only from a specific class of
bonds (for instance bonds issued by the UK government) yield curves built from the money
market use prices of "cash" from today's LIBOR rates, which determine the "short end" of the
curve i.e. for t ≤ 3m, futures which determine the mid-section of the curve (3m ≤ t ≤ 15m)
and interest rate swaps which determine the "long end" (1y ≤ t ≤ 60y).