Term Structure of Interest Rates – Understanding Bond and Yield Curves

What is the Term Structure Of Interest Rates?

The term structure of interest rates is commonly known as the yield curve.  When you invest money into interest-bearing security, the amount of interest paid will vary depending on the length of the investment term. In other words, a savings bond with a one-year term may pay a fairly low-interest rate.  But, if you invest in a bond with a ten-year term, you may receive a higher rate of interest. When we discuss how the length of investment affects a security’s interest rate, we are talking about the security’s term structure.

The term structure depicts the interest rates of similar quality bonds at different maturities.  There is no difference between the term structure and a yield curve.  The yield curve is simply another name to describe the term structure of interest rates.  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.  As a result, the term structure of interest rates reflects the expectations of market participants.  It reflects anticipated changes in interest rates and investor assessment of monetary policy conditions. One commonly used yield curve compares the three-month, two-year, five-year, 10-year, and 30-year U.S. Treasury debt.

(Source: masterclass.com & investopedia.com)

The Term Structure Of Interest Rates – A Deeper Look

The term structure of interest rates shows the various yields that are currently being offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term, and long-term bonds. Essentially, it 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.  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.  It also reflects investor assessment of monetary policy conditions.

1. 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.
2. 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.
3. Flat—very little variation between short and long-term yields. This signals that the market is unsure about the future direction of the economy.

(Source: ibid)

Why Does the Term Structure of Interest Rates Matter?

In general, the slope of the yield curve tends to be positive. This indicates that investors expect a higher rate of return for taking a risk and lending their money for a longer time period.  Many economists also believe that a steep positive curve means that investors expect strong future economic growth.  It points toward higher future inflation and thus higher interest rates.  A sharply inverted curve means that investors expect sluggish economic growth with lower future inflation.  And, as a result, lower interest rates in the future. A flat curve generally indicates that investors are unsure about future economic growth and inflation.

Generally, the term structure of interest rates is a good measure of future economic growth expectations. If there is a highly positive normal curve, it is a signal investors believe future economic growth to be strong and inflation high. If there is a highly negative inverted curve, it is a signal investors believe future economic growth to be sluggish and inflation low. A flat yield curve means investors are unsure about the future. (Source: ibid)

The yield curve changes because a component of the supply and demand for short-term, medium-term, and long-term bonds varies somewhat, independently. For instance, when interest rates rise, the demand for short-term bonds increases faster than the demand for long-term bonds, flattening the yield curve. Such was the case in 2006 when T-bills were paying the same high rate as 30-year Treasury bonds.

The yield curve has 3 characteristics:

1. The change in yields of different term bonds tends to move in the same direction.
2. The yields on short-term bonds are more volatile than long-term bonds.
3. The yields on long-term bonds tend to be higher than short-term bonds.

(Source: thismatter.com)

The U.S. Treasury Yield Curve

The U.S. Treasury yield curve is considered the benchmark for the credit market.  It reports the yields of risk-free fixed income investments across a range of maturities. In the credit market, banks and lenders use this benchmark as a gauge for determining lending and savings rates. Yields along the U.S. Treasury yield curve are primarily influenced by the Federal Reserve’s federal funds rate. Other yield curves can also be developed based upon a comparison of credit investments with similar risk characteristics.

Most often, the Treasury yield curve is upward-sloping. One basic explanation for this phenomenon is that investors demand higher interest rates for longer-term investments.  This is compensation for investing their money in longer-duration investments. Occasionally, long-term yields may fall below short-term yields.  This creates an inverted yield curve that is generally regarded as a harbinger of recession.

(Source: investopedia.com)

The Outlook for the Overall Credit Market

The direction of the yield curve can be used to judge the overall credit market environment. A flattening of the yield curve means longer-term rates are falling in comparison to short-term rates.  This could have implications for a recession. When short-term rates begin to exceed long-term rates, the yield curve is inverted.  A yield curve inversion signals a recession is likely occurring or approaching.

When longer-term rates fall below shorter-term rates, the outlook for credit over the long term is weak. This is often consistent with a weak or recessionary economy. Other factors, including foreign demand for U.S. Treasuries, can also result in an inverted yield curve.  Historically, an inverted yield curve has been an indicator of an impending recession in the United States.

(Source: ibid)

The Term Structure of Interest Rates – Final Words

On Wall Street, the yield curve is used to predict changes in economic output and growth. The bond yields of both short-term and long-term debt securities tend to reveal a lot about the overall state of the U.S. economy.  In fact, the economy of any nation where government-issued debt is considered reliable investment security.

The bond yield curve gives a general indication of future interest rates.  In turn, this can predict an economy’s expansion or contraction.  Therefore, yield curves and changes in these curves can provide a great deal of information. In the 1990s, Duke University professor Campbell Harvey found that inverted yield curves have preceded the last five U.S. recessions. Changes in the shape of the term structure of interest rates can also have an impact on portfolio returns.  Interest yield returns make some bonds relatively more or less valuable compared to other bonds. These concepts are part of what motivates analysts and investors to study the term structure of interest rates carefully.

(Source: investinganswers.com)

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