What Is the Term Structure of Interest Rates?
The term structure of interest rates is a graph that plots the yields of similar-quality bonds against their maturities (from shortest to longest). It is also referred to as the yield curve.
How Does the Term Structure of Interest Rates Work?
A term structure of interest rate shows the various yields currently offered on bonds of different maturities. It enables investors to quickly compare the yields offered on short-term, medium-term, and long-term bonds.
Term Structure of Interest Rate Types
Term structures of interest rates take three primary shapes: normal, inverted, and flat.
Only bonds of similar risk are plotted on the same yield curve. The most common type of yield curve plots Treasury securities because they are considered risk-free and are therefore a benchmark for determining the yield on other types of debt.
Investors who are able to predict how the term structure of interest rates shift can invest accordingly and take advantage of the corresponding changes in bond prices.
Note: These charts don’t plot coupon rates against a range of maturities. That graph is called the spot curve.
Normal Yield Curve
If short-term yields are lower than long-term yields, the curve slopes upwards and is called a positive or normal yield curve:
In general, when the term structure of interest rates curve is positive, it indicates that investors desire a higher rate of return for taking an increased risk of lending their money over a longer period of time.
Many economists believe that a steep positive curve means that investors expect strong future economic growth with higher future inflation (and thus higher interest rates).
Inverted Yield Curve
If short-term yields are higher than long-term yields, the curve slopes downwards and is called a negative or inverted yield curve:
A sharply inverted curve means that investors expect sluggish economic growth with lower future inflation (and thus lower interest rates).
Flat Term Structure
A flat yield curve exists when there is little-to-no variation between short- and long-term yield rates:
A flat curve generally indicates that investors are unsure about future economic growth and inflation.
Who Determines Term Structure of Interest Rates?
The term structure of interest rates is calculated and published by The Wall Street Journal, the Federal Reserve, and a variety of other financial institutions. Interest rates are typically provided via the Treasury website by 6:00 p.m. EST each trading day.
Why Is the Term Structure of Interest Rates Important?
Because the term structure of interest rates is generally indicative of future interest rates (which are indicative of an economy's expansion or contraction), changes in the yield curve can provide a great deal of information.
In the 1990s, Duke Professor Campbell Harvey found that inverted yield curves have preceded the last five US recessions.
Changes in these curves can also have an impact on portfolio returns by making certain bonds more or less valuable compared to other bonds.
Table of Contents
- What Is the Term Structure of Interest Rates?
- How Does the Term Structure of Interest Rates Work?
- Term Structure of Interest Rate Types
- Who Determines Term Structure of Interest Rates?
- Why Is the Term Structure of Interest Rates Important?