The Strategic Bond Investor by Anthony Crescenzi

Author:Anthony Crescenzi
Language: eng
Format: epub
Publisher: McGraw-Hill Education
Published: 2021-06-15T00:00:00+00:00

Traditional Explanations for the Shape of the Yield Curve

There are many explanations for the different shapes of the yield curve. Ten factors are most prominent. Before we get into them, let’s look at a few of the more traditional theories. There are three that are often cited: the expectations theory, the liquidity preference theory, and the market segmentation theory.

The expectations theory is based on the notion that the yield curve’s shape is purely a function of investors’ expectations of future interest rates. According to this theory, when the yield curve is upward-sloping, it reflects expectations that future short-term interest rates will rise. Similarly, an inverted yield curve reflects expectations that future short-term interest rates will fall. In a flat yield curve environment, short-term interest rates are expected to be mostly constant. To some extent the pure expectations theory is similar to the policy anticipation hypothesis described earlier in this chapter because both theories are strongly influenced by expectations about monetary policy.

The liquidity preference theory holds that yields on longer-term maturities are higher than yields on short-term maturities because investors want additional compensation for the increased risks associated with holding longer-term maturities. This is also known as the term premium or liquidity premium. Investors recognize that maturity and price volatility are directly related. They also recognize that there are many other uncertainties in owning longer-term maturities compared with owning short-term maturities. It is therefore rational to think that investors want compensation for the added risks involved in owning long-term maturities, especially for corporate bonds. Unlike Treasuries, credit risks on corporate bonds are subject to considerable uncertainties in the distant future. As a result, investors demand compensation for those risks, pushing long-term interest rates above short-term interest rates. This seems to make sense, because today’s star company may be a laggard or perhaps not even exist 30 years from now. One glance at a list of the top ten companies ranked by market capitalization today versus 20 years ago makes this point clear: only one company (Microsoft) remains in the top ten, as shown in Figure 8.5.6 Notice the significant change in the types of industries that are on the list. This reflects the changing nature of the economy.

FIGURE 8.5 Today’s top companies might not be tomorrow’s.

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