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What shapes yields?
Theories behind what impacts the shape of the yield curve

The term structure of interest rates is the phrase used to describe the relationship between interest rates and terms to maturity - i.e. the shape of the yield curve. Typically, the longer a bond's term to maturity, the higher the yield. I've written previously about how interest rates impact stock and bond prices, and why. This week's article takes a step back and looks at what factors are at work to shape the interest rate picture at any point in time.

Pure expectations theory

Very simply, the pure expectations theory says that expectations of the future are embedded in today's yields and terms. More specifically, this theory considers each of the following three separate scenarios to have the identical expected returns over the next two years:

  • a one-year bond held to maturity, then rolled over to another one-year bond and held to maturity;
  • a two-year bond held to maturity; and
  • a three-year bond held for two years.

    In other words it says that the one-year bond yield in twelve months' time can be inferred from the yields on both one- and two- year bond yields today. Based on recent yields, this theory says that the one-year government of Canada bond yield will rise from about 2.9% to 3.6% over the next twelve months.

    Don't take this as law, but think about the theory's basic premise. Today's prices and yields have embedded in them the aggregation of all market participants' expectations for the future. Sound familiar? I've written that same statement about stock prices many times. There is some intuitive appeal to this theory as well as some empirical support.

    Liquidity preference theory

    This theory, related to "pure expectations", says that rational investors (which most are not in reality) should not have a preference over one of the three bullet points noted above. However, this theory further suggests that a "liquidity premium" (i.e. some extra yield) is demanded by investors to compensate for greater uncertainty.

    In other words, suppose you have money to invest for two years. You can buy a two-year bond, and simply hold it to maturity; or you can buy a three-year bond and sell it in two years when you need the money. This theory says an investor will have a preference for the bond that better meets her liquidity needs. Further, it states that "the market" will have to induce the investor into buying the three-year bond by offering a yield that is slightly higher than the two-year bond. That difference between the two- and three- year bond yields is called the liquidity premium.

    Again, this makes sense since investors will only enter into investments having greater uncertainty if there is potential to earn higher returns.

    Market segmentation theory

    Perhaps the easiest of the three theories to comprehend, the market segmentation theory says that yields of bonds of different terms are simply driven by the pure forces of supply and demand.

    The last five years have been a great example of how this theory has played out in reality. We know that our government was spending more money than was coming into its coffers - i.e. running a deficit - for decades. To finance this deficit, it issued bonds to borrow money. Often times, the government issued very long term bonds - having maturities of twenty and thirty years.

    As many governments, including Canada's, began getting their fiscal houses in order, deficits shrunk - eventually turning into surpluses. The lack of a shortfall meant that the government no longer needed to continue issuing new bonds. In fact, it began repaying some. The result: the supply of new, long-term bonds began falling.

    However, financial institutions - like pension funds, life insurance companies, etc. - continued to need long-term bonds to finance their long-term obligations.

    Diminishing supply, combined with level or rising demand will eventually lead to rising prices. But when bonds prices rise, yields fall.

    Why should you care about these theories? Well, it seems that all three have some basis in common sense and, at various times, we can see each one influencing rates at various maturities. Also, the shape of the yield curve can sometimes hold a picture of the economy's future. And this discussion sets the stage for next week's article.

    Next week: Some advice on what to do with bond holdings today.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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