Term Structure Thy

THE TERM STRUCTURE OF INTEREST RATES

(YIELD CURVE)

The hypothetical yield curve is a "line-of-best-fit" drawn through different interest-maturity combinations.
The curve forms a graphical picture of market interest rates at any given time.

The Yield Curve (or the "Term Structure of Interest Rates") is a graphical relationship of interest rates and terms of maturity for fixed income products.

A "typical, normal" yield curve is a graph that is upward sloping, to the right.

[U.S. Treasury Yield Curve]

If there is a picture "worth a thousand words" it would be a yield curve. So much is said about the condition of the economy and the market by the shape of the Curve.

Some particulars about the Yield Curve:

	The Treasury Yield Curve is pictured in the Wall Street Journal daily.
	The United States Treasury 'sets the curve.' Whenever the US Government borrows money, the bonds, notes and bills are auctioned usually to large banks and brokerage firms. The price and yield that wins the auction sets the rate.
	Corporations that need funding through a bond issue look to the Treasury Yield Curve to determine what they have to pay for money. They can't pay lower than Treasury, their bonds would not sell (investors would not consciously buy a General Electric bond that paid 5% if the comparable Treasury paid 5 1/4%).
	The interest rates that a company pays for money is largely determined by their credit rating. The lower the credit rating, the higher interest rates that they have to pay. We measure risk in the curve vertically; as credit ratings get lower (worse), the yield curve is higher above the Treasury curve.
	We also measure risk horizontally; the spread between the rate on the left side of the curve versus the rate on the right side of the curve, signals what the market thinks of inflation and future rates. In the curve above, the near-term rate is right about 2.25%; the long-end of the curve is at a rate of about 5.4%. There is a 3.15% spread between the two. The larger the spread, the steeper the curve. A steep curve tells us that the Market believes that higher interest rates are in our future, that interest rates in the future will increase. A relatively flat yield curve has a small spread and indicates that the Market believes that interest rates will remain relatively unchanged, that inflation is under control and will not soon increase.
	There are examples of INVERTED yield curves below. These point to a recession, short-term rates are higher than long-term rates. In these instances financial institutions curtail their lending or refuse to lend increasing the change for recession.
	Every recession was preceded by an inverted yield curve.

Three Theories on the shape of the YIELD CURVE

Rational Expectations Theory: (The easiest, most strait forward of the theories) This theory states that investors expect to be paid a higher interest rate when investing for a longer term. This is the most plausible, most referenced theory of the yield curve's shape. To "go out on the curve" means purchasing longer termed securities and to do so invites more risk.

Liquidity Preference Theory: [A little tougher to understand] An investor will sacrifice a higher yield for a lower yield by lending short term instead of long term. An investor will pay a higher price (and accept a lower yield) to have a shorter term, more liquid security. Thus a 'liquidity preference.'

Market Segmentation Theory: {The toughest one} This theory asserts that the yield curve is not smooth and continuous but exists as broken segments, each with their own set of terms and rates. Businesses operate in certain areas of the curve. Banks, for example, tend to prefer to lend money short term, and borrow short term. Insurance companies have products (like life insurance) that are primarily long-term in nature, other companies tend to buy and sell securities in the "middle" of the curve. Market Segmentation states that the "segments" are independent of each other.

Some YIELD CURVE comparisons

This is a picture of a yield curve from June of 2000; the inverted shape is NOT a normal curve. EVERY recession began with an inverted yield curve and this situation was no exception, this curve was right before the recession of 2001.

Same curve as above, but one month later...July, 2000.

Click here for: August, 2005 Article on the Fed, Inverted Yield Curves and their affects on the economy and the banking system.

Two Yield Schedules (a tabular form of a yield curve was taken from Bloomberg Systems (an investment information company)) toward the end of 2001. After the Fed lowered interest rates for 11 times in 2001, the curve did NOT have a parallel shift downward.

Treasury Yield Curve	12/31/00	11/6/01	Change
3 month	5.89%	1.85%	(4.04%)
6 month	5.70%	1.82%	(3.88%)
2 year	5.09%	2.34%	(2.68%)
5 year	4.97%	3.49%	(1.48%)
10 year	5.11%	4.27%	(0.84%)
30 year	5.46%	4.86%	(0.60%)

Agency Yield Curve	12/31/00	11/6/01	Change
3 month	6.29%	1.92%	(4.37%)
6 month	6.10%	1.86%	(4.24%)
2 year	5.57%	2.62%	(2.95%)
5 year	5.77%	4.08%	(1.69%)
10 year	6.07%	4.92%	(1.15%)
30 year	6.18%	5.65%	(0.53%)