Unit 03:

The Term Structure of Interest Rates

Frederich Kirsten
 Contents of this Lecture

• Introduction
• Definitions and empirical facts
• Theories of the term structure of interest rates
• Monetary policy and the term structure of interest
rates
 Lecture Objectives

• At the end of this lecture :

• We would understand the link between interest rates of different
maturities
• We would understand the facts and the theories of the term
structure
• We would appreciate the importance of the term structure for
monetary policy
 Introduction
• In previous studies (for example the analysis of the loanable funds framework)
• We assumed that there is only one bond and so only one interest rate for the
economy as a whole.
• In the real world, however, different types of credit market instruments exist, with
potentially different interest rates.
• For example, we have government bond with different maturities (3 months, 6
months, 1 year, 5 years, 10 years). We also have private securities(mortgage loan,
car loan, etc.)
 Introduction

• Bonds may differ in terms of their maturities-

• Definition: The relationship between interest rates on bonds of
different maturities is called the term structure of interest rates
• Also…bonds may have same maturity but may still differ in
terms of their riskiness.
• Definition: The relationship between interest rates on bonds with the
same term to maturity is called the risk structure of interest rates
Risk Structure of Interest Rates
• Interest rates on different categories of bonds differs from
one another in a given year
• Corporate bonds tend to have higher interest rates than US
government bonds.
• The spread between the interest rates on US corporate
bonds and US government bonds varies over time. In
particular, the spread tends to widen during periods of
recession or depression.
• These observable facts are explainable based on these
factors: (1) Default risk (2) Liquidity (3) Income tax
considerations.
 Risk Structure of Interest Rates: Default risk

• Default risk: Refers to the probability that the issue of

the bond (the borrower) will be unable to make interest
payments on the bond or to pay off the face value of the
bond when it matures.
• From the loanable funds analysis, we deduce that when
the riskiness of a bond increases, the interest rate rises;
this implies that bonds with higher default risk will have
higher interest rates.
 Risk Structure of Interest Rates: Default risk

• Using default risk to explain why corporate bonds have higher interest rates-
• Treasury bonds are considered ‘default free’. Corporates sometimes do default on their
bonds. Corporate bonds tend to have higher interest rates than government bonds. The
spread between interest rates on bonds with default risk and interest rates on default free
bonds is called the risk premium.
• Using default risk theory to explain the variations in interest rates on
corporate and government bonds -
• During recessions (expansions) default risk on corporate bonds increases (decreases) during
these different periods, the risk premium also rises (reduces)
Corporate Bonds and Default Risk
 Liquidity
• Liquidity: the relative ease with which an asset can be converted into cash.
• Factors that affect liquidity-Transactions cost (of selling an asset); the number
of buyers and sellers in a bond market, etc.
• Treasury bonds are more widely and actively traded than corporate bonds.
Hence, government bonds are more liquid than corporate bonds.
• liquidity can also explain fact why corporate bonds tend to have higher interest
rates than government bonds
 Income Tax Considerations

• Some types of bond interest payments are exempt from income tax . In US
municipal bonds (bonds issued by state and local governments) are federal
income tax free.
• Tax-free advantage increases the demand for municipal bonds and thereby
makes their interest rate lower
 Income Tax Considerations
• Unlike the US government, state
and local governments sometimes
do go bankrupt. municipal bonds
are not as widely-traded, and
hence not as liquid, as US
government bonds
 Term Structure of Interest Rates
• Bonds with identical risk, liquidity, and tax characteristics may have
different interest rates because their times remaining to maturity are
different. The term structure of interest rates is the relationship between
interest rates which differ only in maturities.
• Maturity refers to a time period at the end of which the financial security
will cease to exist and the principal is repaid with interest
• The yield curve: a plot of interest rates (yields) on bonds with different
maturities.
 Information Contents in the Slope of Yield
Curves
• The slope of the yield curve is the difference
between a longer maturity interest rate and a
shorter maturity interest rate.
1. When long-term rates are above short-term
rates; we say that the yield curve is upward
sloping
2. When long-term rates and short-term rates are
the same; we say that the yield curve is flat
3. When long-term rates are below short-term
rates; we say that the yield curve is inverted
 Three important facts
about the term structure of interest rates
• Fact 1: Interest rates on bonds of different maturities tend to move
together over time.
• Fact 2: The yield curve can slope up or down. It tends to slope up
when short-term interest rates are low, and tends to slope down
when short-term interest rates are high.
• Fact 3: Yield curves almost always slope upward
 Theories of the Term Structure
• Any ("good") theory of the term structure of interest rates must be
able to explain these 3 facts. Three theories have been proposed
namely;
• The Expectations Hypothesis – explains facts (1) and (2).
• Segmented Markets Theory – explains fact (3).
• Liquidity Premium or Preferred Habitat Theory – a combination of
the first two theories – explains all three facts.
 Expectation Theory
• The expectations theory (or the expectations hypothesis) states that: the
interest rate on a long-term bond will equal an average of the short-term
interest rates that people expect to occur over the life of the long-term bond.
• Key assumption of this theory: Investors regard bonds with different
maturities to be perfect substitutes. Buyers of bonds do not prefer bonds of
one maturity over another; they will not hold any quantity of a bond if its
expected return is less than that of another bond with a different maturity
• Let’s see how this assumption explains the expectations hypothesis
 Expectations Hypothesis
• To understand how this assumption leads to the expectations theory
consider an investor who wants to invest R1000000 for the next two years.
Assume that there exist in the market 2 bonds; a 1-year maturity bond and
a 2-year maturity bond. So, the investor has at least two options:
• Strategy One: Buy a one-year bond, and when it matures in one year, buy
another one-year bond.
• Strategy 2: Buy a two-year bond and hold it until maturity.
 Expectations Hypothesis
• If bonds of different maturities really are perfect substitutes, then these
two strategies must provide the same expected return.
• For example: If the interest rate on a one-year bond is 10 % today and is
expected to be 12 % one year from now, then the annualized interest rate
on a two-year bond today must be 11%.
• Let us generalize this argument further
 Expectation Hypothesis
• Let = today’s (time t) interest rate on a one-year bond
• Let = expected interest rate on a one-year bond next year (time t + 1)
• Let = today’s (time t) annualized interest rate on a two-year bond
• Then the expected return on Strategy One can be calculated as
• ) = 1+++
 Expectation Hypothesis
• Expected return on Strategy Two can be calculated
• = ++

• If both strategies are to have the same expected returns, then

• =
• =
• Thus, the annualized interest rate on the two-year bond is an average of
the one-year rates that are expected to prevail over the next two years
 Expectation Hypothesis
• We can generalize this result for a n-period bond, let be today’s annualized rates on
n –period bond

• Empirical example 1
• Suppose =5%; =6%; =7%; =8% and =9%
• =; what is and ?
• What pattern do you observe?
 Expectation Hypothesis
• In the previous example, the 1 year rate is expected to rise, hence the
yield curve slopes upwards.
• Empirical example 2
• Suppose =9%; =8%; =7%; =6% and =5%
• =; what is and ?
• In this example, the one year-rate is expected to fall, and so the yield
curve slopes down, or is inverted.
 Lessons from Expectation Hypothesis
• Can the expectations theory explain the 3 empirical facts of the term
structure?
• The expectations hypothesis can explain Fact 1. Given the market
expectations, if the short-term interest rates increase (if increases) long-
term interest rates () will also tend to increase. If the short-term interest
rates decrease, long-term interest rates will also decrease. So, the
expectation theory can explain the fact that interest rates of different
maturities tend to move together (in the same direction).
 Lessons from Expectation Hypothesis
• The expectations hypothesis can also explain Fact 2. The expectations
theory can also explain the fact that when short-term interest rates are low,
yield curves are more likely to have an upward slope; and when short-term
rates are high, yield curves are more likely to slope downward and be
inverted.
• In fact, when short-term interest rates are unusually high, people will
expect them to revert back (decrease) to their normal levels in the future.
This means that the terms ; j = 1, 2, ..., n-1 are smaller than the current
short term rate . (meaning the yield curve is inverted).
 Lessons from Expectation Hypothesis
• Similarly, when short-term rates are unusually too low, people will expect
them to increase in the future to their normal levels. This implies that, long-
term rates will be above short-term rates (meaning the yield curve is
upward sloping)
• But the expectations hypothesis cannot explain Fact 3. Since short-term
interest rates are as likely to rise as they are to fall, the expectations
hypothesis predicts that the yield curve is as likely to slope upward as it is
to slope down. It cannot explain why most of the time the yield curve
slopes up
 The Segmented Markets Theory
• Unlike the expectations hypothesis, this theory assumes that investors regard markets for bonds of different
maturities as completely separate, or segmented. That is, bonds of different maturities are not substitutes at all.
• Examples:
• If you are planning to go in vacations for next year, you will prefer to save in a 1-year maturity bond
(Investors saving for a short period of time buy only short-term bonds)
• But, someone saving for retirement may prefer investing in a long-term bond (Investors saving for a long
period of time buy only long-term bonds)
• If bonds of different maturities are not substitutes at all, then the interest rate for each maturity is determined
solely by the supply of and demand for bonds of that maturity, with no effects from interest rates on bonds of
other maturities.
 Segmented Markets Theory
• Segmented markets theory can explain Fact 3. If most investors prefer
short-term bonds, the demand for short-term bonds will be greater than the
demand for long-term bonds.
• Hence, the interest rate on short-term bonds will be lower than the interest
rate on long-term bonds.
• That is, the yield curve will typically slope upward.
• Why might most investors prefer short-term bonds?
 Why most Investors Prefer Short-Term
Bonds:
• Returns on bonds are not risk free, even including treasury bonds. For
simplicity, let’s just assume an investor is contemplating on buying
either a short-term or long term government bond
• Remember what matters to the investor is the real returns on the bond
he/ she wishes to purchase.
• What are some of the factors that can affect the real returns of bonds?
 Why most Investors Prefer Short-Term Bonds:

• Uncertainties in future inflation

• Uncertainty about future inflation will create uncertainty about the real return. The
further the future, the higher the uncertainty about the inflation level. So long-term
bonds contain higher inflation risk than short-term bonds.
• Interest Rates Risk
• Investors would want to avoid the risk of incurring capital losses if they need to sell
long-term bonds before maturity. Suppose that you buy a 10-year bond, and that
after only 5 years you want to resell the bond.
 Why most Investors Prefer Short-Term Bonds:

• Interest Rates Risk

• There is a risk that the current price at which you can sell the bond is much less
than the price at which you bought the bond 5 years ago. In this case you will
make a loss if you sell your bond at the current (lower) price. The longer the
maturity of the bond, the greater the uncertainty about the future bond price.
Thus, it is riskier to hold a long-term bond relative to a short-term bond.
• Finally, most investors may not want to lock up their funds for a longer period and
thus would to take advantage of the greater liquidity of short-term bonds.
 Lessons from The Segmented Markets
Theory
• If in general, short-term bonds are preferred over long-term
bonds, the demand of short-term bonds will be high relative
to the demand of long-term bonds. This implies that the price
of short-term bonds will be higher relative to the long-term
bond prices. Thus interest rates on short-term bonds will
usually be lower than interest rates on longer maturity bonds-
Fact 3
• What about Facts 1 and 2?
 Lessons from The Segmented Markets
Theory
• Segmented market theory cannot explain Fact 1: If bonds of different
maturities are really traded in completely separated markets and are not
substitutes at all, then their interest rates should show no tendency to
move together.
• Also the theory cannot explain Fact 2: Unless we assume that investors
preferences for bonds of different maturities changes significantly over
time, so that they sometimes prefer short-term bonds and sometimes
prefer long-term bonds.
 Liquidity Premium or Preferred Habitat
Theory
• We have seen that none of the two reviewed theories can independently
explain all the three facts
• The expectations hypothesis can explain two of our three facts (Fact 1 and Fact 2)
• The segmented markets theory can explain only Fact 3.
• Another observation-both theories assumptions are very strict
• Bonds should be perfect substitutes (expectation hypothesis)
• Bonds of different maturities not substitutes (segmented markets)
 Liquidity Premium or Preferred Habitat
Theory
• Liquidity Premium theory is derived from the two theories by relaxing the
strict assumptions.
• Assumption of liquidity premium or preferred habitat theory : investors
regard bonds of different maturities as substitutes, but not perfect substitutes.
• Since holding longer maturity bonds is more riskier, investors will prefer
holding short-term bonds.
• Investors will therefore ask an additional positive compensation for the risk contained
in long-term bonds in order to hold them.
How the Liquidity Premium theory Relates with Expectation
Hypothesis and the Segmented Market Theories

• Consider the expectation hypothesis short and long term interest rates relationship

• With the liquidity premium theory, the equation above is modified to

• +; Where is called the liquidity premium for the n-year bond at time t.
 Lessons from the Liquidity Premium or
Preferred Habitat Theory
• +
• The part of the equation in red is related to the expectations hypothesis.
• It tells us that investors have interests on returns on bonds of different maturities. Implies
investors would not let expected returns on different investment to be far apart.
• The part of the equation in green is related to the segmented market theory
• It illustrates how investors have preferences for some maturities over others. For instance if
investors preferred habitat is in short-term bonds
• What happens to demand for short-term bonds? What happens to interest rates on short-term
bonds relative to long term bonds?
 Lessons from the Liquidity Premium or
Preferred Habitat Theory
• If investors prefer short-term bonds then the liquidity / term premium ()
will be positive and increases as n increases.
• Thus the liquidity or term premium is an incentive to investors; attracts
them to hold long-term bonds even though their natural preference was
short-term bonds.
• Since the liquidity theory combines the expectations and the segmented
markets theories, it can explain all the 3 empirical facts of the term
structure.
 Lessons from the Liquidity Premium or
Preferred Habitat Theory
• Suppose that investors’ preferred habitat is in short-term bonds, so that
• ( liquidity premium on 2-year bonds) = 0.25%
• = liquidity premium on 5-year bonds = 1%
• When short term rates are expected to rise and =5%; =6%; =7%; =8% and =9%
• + =+
• = += 8%
• Hence, when short-term interest rates are expected to rise, the yield curve
slopes up.
 Lessons from the Liquidity Premium or
Preferred Habitat Theory
• When short-term interest rates are expected to fall slightly:
• Take =9%; =8.75%; =8.50%; =8.25% and =8%
• =+; = 9.5%; Hence, when short-term rates are expected to fall only slightly, the
yield curve still slopes up.
•When short-term rates are expected to fall sharply
• Take =9%; =8%; =7%; =6% and =5%, then =8.75% and = 8%
• Thus when short-term rates are expected to fall sharply the yield curve slopes
down.
 Lessons from the Liquidity Premium or
Preferred Habitat Theory
• Since interest rates at all maturities depend on today’s short-term rate , then they will tend
to move together, rising when it rises and falling when falls.
• The yield curve will slope up if investors expect short-term interest rates to rise or fall
slightly; the yield curve will slope down if investors expect short-term interest rates to
fall sharply. Hence, in general, the yield curve can slope up or down. Moreover, the yield
curve will tend to slope up when short-term interest rates are low–and therefore expected
to rise–while the yield curve will tend to slope down when short-term interest rates are
high–and therefore expected to fall.
• Since the yield curve slopes down only when short-term interest rates are expected to fall
sharply, most of the time the yield curve will slope up.
 Monetary Policy and the term structure
of interest rates
• Central banks like SARB and Federal Reserves can influence quantity of
money and interest rates through different instruments (open market
operations, banks reserve markets)
• Monetary authorities (in normal times) usually ‘play’ with demand and
supply in very short-term government bond markets to affect interest rates
and the quantity of money.
• Remember, the ultimate goal is to increase output, stabilize prices and
moderate long-term interest rates
 Monetary Policy and the term structure
of interest rates
• However, the central bank does not have direct control on some long term
interest rates (mortgage rate, car loan rate, etc) which matter for aggregate
demand.
• By changing its instrument rate (very short-term rate), the central bank
expects that its actions will be transmitted to other interest rates and affect
the aggregate demand components.
• It is then important for the central bank to understand how interest rates of
different maturities are linked in order to take the proper actions.
 Monetary Policy and the term structure
of interest rates
• Information contained in the the term structure that is very useful in
central banks policy making activities includes-
• Market participants expectations about the future policy interest rate:
The ability of the central bank to affect the long-term interest rates
depends on the market expectations about the central bank policy rate
(short-term rate)
• Market expectations about the future inflation rate
 Implications of the Expectations Theory on
Policy Actions
• Assume that the expectation theory holds.
• Today’s (time t) annualized interest rate on a two-year bond is given as-
• ; where = today’s (time t) interest rate on a one-year bond and = expected
interest rate on a one-year bond next year (time t + 1)
• Thus, in order for an investor to make a good investment decision today over
the next 2 periods, an investor must forecast the 1-period (the short-term) rate
next year i.e.
• What factor could inform the investor on next year’s expected interest rate?
 Implications of the Expectations Theory on
Policy Actions
• This short-term rate will depend on the decisions of the
central bank. Thus, the investor must anticipate the
central bank policy.
• or
• What does the current term structure tell us about the
future short-term interest rate?
 Implications of the Expectations Theory on
Policy Actions
• Supposed the annualized interest rate on a two-year bond
is above today’s (time t) interest rate on a one-year bond
• This implies that or
• Meaning that the market expects the short-term interest
rate to be higher next period than the current value.
• That is
 Implications of the Expectations Theory on
Policy Actions
• If the central bank wants for example to pursue a
tightening policy, it would use open market operations
to affect short-term rates
• Expectations about the path of future monetary policy would
then help to determine the final impact of this policy on the
long-term interest rates.
 Expectations, Credibility and Policy
• The central bank can guide (and convince) the public about its future
policy path by pre-announcing the policy future actions in order to
achieve better results but it all depends on its credibility in the market. If
the market believes on the announced policy path, the central bank can
easily achieve a desired result. Otherwise, monetary policy will be
ineffective in affecting long-term rates and the aggregate demand.
• Managing public expectations is then part of the monetary policy strategy
and expectations depend on the central bank credibility.
 Expectations, Credibility and Policy
• For example, assume that the current 1-period interest rate is = 5% and
initially the public expects the 1-period rate to remain the same next
period i.e. = 5%

• Now assume that the central bank wants to pursue a tightening policy. it
increases the current short rate from 5% to 6% and then announces that
next period he is likely to set the interest rate at 8%
 Expectations, Credibility and Policy
• If the public believes the government, then = 8%

• However, if the public do not trust the central bank announcement and
instead believe that the central bank is likely to decrease the short-term
rate next period to say 4%, then = 4% and
• In this case, the long-term interest will remain unchanged and the
monetary policy rate increase has no effect on long-term rates.
 Reading List
1. Frederic Mishkin: Chapters 4, 5 & 6- Understanding Interest Rates;
Behaviour of Interest Rates & Risk and Term Structure of Interest Rates
2. Additional readings:
3. Ojwang’ George Omondi: Term Structure of Interest Rates. Review of a
Theory of the Term Structure of Interest Rates
4. Gregory Mankiw: The Term Structure of Interest Rates Revisited.