What is “Term Structure of Interest Rates”?
The term structure of interest rates refers to the market interest rates (i.e. spot rates) on bonds with different lengths of time to maturity but with the same or similar risk (i.e. with the same credit rating). It measures the relationship among yields on bonds that differ only in their term to maturity. For example, you have the term structure of benchmark rates for ‘risk-free’ government bonds (i.e. yields on government bonds) of varying or different maturities that range from the very short-term to long-term.
In the US, there are treasuries of varying maturities: 1 month, 3 months, 1 year, 10 years, and 30 years, etc. Suppose the yields on the same are 0.5%, 1.2%, 2.7%, 4%, and 5% respectively (i.e. there are different yields for treasuries of different maturities). A graph of this term structure of interest rates is known as the yield curve.
Key Learning Points
- The term structure of interest rates is also known as the ‘yield curve’
- It measures the relationship of yields on bonds of similar quality but with different maturity dates
- There are three important terms to be aware of when referring to the term structure of interest rates: spot rates, the present value of a bond, and yield to maturity
- The term structure of interest rates is important for several reasons and has mainly three shapes – positive, inverted (negative) or flat
Term Structure of Interest Rates –spot rates, present value, and yield to maturity
When referring to the term structure of interest rates, one should be aware of terms such as spot rates, the present value of a bond, and yield to maturity.
Spot Rates: assume an investor has two zero-coupon bonds – Bond A (one-year bond) and Bond B (two-year bond) and both have par values of US$1,000. The interest on the one-year bond and two-year bond is 6% and 8% respectively. These two rates of interest are examples of spot rates.
Present value: given below is an example of the calculation of the price of a bond (i.e. its present value) using spot rates. The price of a bond (i.e. its present value – PV) with a par value of US$100, maturity of 3 years, and having a 7% coupon payment (annual) is calculated below using spot rates (1-year, 2-year, and 3-year). The present value is calculated by discounting the cash flows each year by their respective spot rate.
Yield-to-Maturity (YTM): this is the total rate of return on a bond, if it is held until maturity, all coupon and principal amounts are paid as per the schedule and the investor is able to reinvest the coupon payments at the same yield.
Typically, the formula used to approximate the YTM of a bond is:
YTM (%) = C + (FV – PV/T)
FV + PV/2
C= Coupon or interest payment on the bond
FV = Face value of the bond
PV = Current price or value of the bond
T = Years to Maturity
Given below is an example:
Term Structure of Interest Rates – Salient Points
The term structure of interest rates is important as it helps to explain the ways by which changes in short-term interest rates impact the level of long-term interest rates in an economy. Further, the term structure may provide valuable information about the expectations of financial market participants vis-à-vis future changes in interest rates and their assessment of monetary policy conditions. It tends to be a sound measure of expectations of future economic growth in an economy, and an indicator of market expectations of future interest and inflation rates.
The term structure of interest rates also enables investors to expeditiously compare yields offered on short, medium-term, and long-term bonds.
The term structure of interest rates tends to have mainly three shapes – positive, negative, and flat. If short-term yields are lower (higher) than long-term yields, the term structure of interest rates will be positive (negative or inverted). When plotted on a graph this will yield a positive (negative) yield curve. Further, when there is hardly any or no variation between short-term and long-term yields, we have what is referred to as a flat-term structure of interest rates and when plotted, it yields a flat yield curve.
When the term structure of interest rates is positive, it usually indicates that investors expect strong economic growth, along with higher inflation in the future, and consequently higher interest rates. On the other hand, a sharply negative term structure of interest rates indicates that investors expect slower economic growth in the future, along with lower inflation and interest rates.
A flat-term structure of interest rates indicates that investors are uncertain about future growth and inflation.