THE TERM STRUCTURE OF INTEREST ANALYSIS.

The term structure of interest rates, also known as the yield curve, is a very common bond
valuation method. Constructed by graphing the yield to maturities and the respective
maturity dates of benchmark fixed-income securities, the yield curve is a measure of the
market's expectations of future interest rates given the current market conditions.
Treasuries, issued by the federal government, are considered risk-free, and as such, their
yields are often used as the benchmarks for fixed-income securities with the same
maturities. The term structure of interest rates is graphed as though each coupon payment
of a noncallable fixed-income security were a zero-coupon bond that “matures” on the coupon
payment date. The exact shape of the curve can be different at any point in time. So if the
normal yield curve changes shape, it tells investors that they may need to change their
outlook on the economy.

There are three main patterns created by the term structure of interest rates:

1) Normal Yield Curve: As its name indicates, this is the yield curve shape that forms
during normal market conditions, wherein investors generally believe that there will be no
significant changes in the economy, such as in inflation rates, and that the economy will
continue to grow at a normal rate. During such conditions, investors expect higher yields for
fixed income instruments with long-term maturities that occur farther into the future. In
other words, the market expects long-term fixed income securities to offer higher yields
than short-term fixed income securities. This is a normal expectation of the market because
short-term instruments generally hold less risk than long-term instruments; the farther into
the future the bond's maturity, the more time and, therefore, uncertainty the bondholder
faces before being paid back the principal. To invest in one instrument for a longer period of
time, an investor needs to be compensated for undertaking the additional risk.

Remember that as general current interest rates increase, the price of a bond will decrease
and its yield will increase.
2) Flat Yield Curve: These curves indicate that the market environment is sending mixed
signals to investors, who are interpreting interest rate movements in various ways. During
such an environment, it is difficult for the market to determine whether interest rates will
move significantly in either direction farther into the future. A flat yield curve usually
occurs when the market is making a transition that emits different but simultaneous
indications of what interest rates will do. In other words, there may be some signals that
short-term interest rates will rise and other signals that long-term interest rates will fall.
This condition will create a curve that is flatter than its normal positive slope. When
the yield curve is flat, investors can maximize their risk/return tradeoff by choosing fixed-
income securities with the least risk, or highest credit quality. In the rare instances wherein
long-term interest rates decline, a flat curve can sometimes lead to an inverted curve.

3) Inverted Yield Curve: These yield curves are rare, and they form during extraordinary
market conditions wherein the expectations of investors are completely the inverse of those
demonstrated by the normal yield curve. In such abnormal market environments, bonds with
maturity dates further into the future are expected to offer lower yields than bonds with
shorter maturities. The inverted yield curve indicates that the market currently expects
interest rates to decline as time moves farther into the future, which in turn means the
market expects yields of long-term bonds to decline. Remember, also, that as interest rates
decrease, bond prices increase and yields decline.

You may be wondering why investors would choose to purchase long-term fixed-income
investments when there is an inverted yield curve, which indicates that investors expect to
receive less compensation for taking on more risk. Some investors, however, interpret an
inverted curve as an indication that the economy will soon experience a slowdown, which
causes future interest rates to give even lower yields. Before a slowdown, it is better to lock
money into long-term investments at present prevailing yields, because future yields will be
even lower.
The Theoretical Spot Rate Curve

Unfortunately, the basic yield curve does not account for securities that have varying coupon
rates. When the yield to maturity was calculated, we assumed that the coupons were
reinvested at an interest rate equal to the coupon rate; therefore, the bond was priced at
par as though prevailing interest rates were equal to the bond's coupon rate.

The spot-rate curve addresses this assumption and accounts for the fact that many
Treasuries offer varying coupons and would therefore not accurately represent similar non-
callable fixed-income securities. If for instance you compared a 10-year bond paying a 7%
coupon with a 10-year Treasury bond that currently has a coupon of 4%, your comparison
wouldn't mean much. Both of the bonds have the same term to maturity, but the 4% coupon
of the Treasury bond would not be an appropriate benchmark for the bond paying 7%. The
spot-rate curve, however, offers a more accurate measure as it adjusts the yield curve so it
reflects any variations in the interest rate of the plotted benchmark. The interest rate
taken from the plot is known as the spot rate.

Estimating the Appropriate Yield.

The following model is used in estimating the appropriate yield.

Yn = Rf,n + DP + LP +TA.

Where;

Yn= Yield of an n-day debt Security

Rf,n= yield of an n day Treasury(risk free) security.

DP= default premium to compensate for credit risk.

LP= liquidity Premium to compensate for less liquidity.

TA= adjustment due to the difference in Tax Status.

These are characteristics identified that explain yield differentials among securities.
Although maturity is another characteristic that can affect the yield, it is not included here
because it is controlled for by matching the maturity of the risk free security on that of the
security of concern.

Illustration Suppose that the three month T-bills annualized rate is 8% and Elizabeth &co.
Plans to issue 90-day commercial paper. Elizabeth will need to determine the default
premium and liquidity premium to offer on its commercial paper to make it as attractive to
investors as a three month T-bill. Tax will be deducted where applicable.

Assume that Elizabeth & co. believes that a 0.7 percent default risk premium, a 0.2 percent
liquidity premium and a 0.3 percent tax adjustment are necessary to sell its commercial
paper to investors. The appropriate yield to be offered on the commercial paper is.

Yn = Rf,n + DP + LP +TA.

=8+ 0.7+0.2+0.3

= 9.2%

As time passes, the appropriate commercial paper rate will change, perhaps because of
changes in risk free rate, default premium, liquidity premium and tax adjustment.

Some corporations may postpone plans to issue commercial paper until the economy improves
and required premium for credit default is reduced. Yet even then, the market rate of
commercial paper may increase if interest rate increases.

If the default risk premium decreases from 0.7 % to 0.5 % but Rf,n increases from 8% to
8.7%, the appropriate yield to be offered on commercial paper would be.

Yn = Rf,n + DP + LP +TA.

=8.7+ 0.5+0.2+0.3

= 9.7%

The strategy to postpone issuing commercial paper would backfire in this example. Even
though the default premium decreased by 0.2 %, the general level of interest rate rose by
0.7% so the net change in the commercial paper rate is 0.5 %

As this example shows the increase in a security’s yield over time does not necessarily mean
that the default premium has increased.

THEORIES OF THE TERMS OF STURCTURE.

Various theories have been used to explain the relationship between maturity and annualized
yield of securities theory include;

EXPECTATIONS THEORY:
According to the expectation theory the term structure of interest (as reflected in the
shape of the yield curve) is determined solely by expectation of future rates.

If investors expect interest rate to decrease in the future, they will prefer to invest in
long-term funds rather than short-term funds because they could lock in today’s interest
rate before interest rates fall. Borrowers will prefer to borrow short-term funds so that
they can re-borrow at lower interest once interest rates decline. Based on the expectation
of lower interest rates in the future, the supply of funds provided by investors will be low
for short term funds and high for long-term funds.

Investors monitor the yield curve to determine the rate exists for securities with various
maturities. If a particular investment strategy is expected to generate a higher return over
the investment horizon, investors may use this strategy. If investors were indifferent to
security maturities they would want the return of any security to equal the compounded yield
of consecutive investment in shorter term securities. i.e. a 2 year security should offer a
return that is similar to the anticipated return from investing in two consecutive two year
securities.

To illustrate these equalities, consider a relationship between interest rates on 2-year

security and a one year security as follows:

(1 + ti2)2= (1 + ti1) (1 + t+1 r1)

Where:

ti2=known annualized interest rate of a two year security as of time t.

ti 1 = known annualized interest rate of a one year security as of time t.

t+1 r1= one-year interest rate that is anticipated as of time t+1(one year ahead)

The term i represent a quoted rate, which is therefore known. Whereas r represents a rate
to be quoted at some point in the future, which is therefore uncertain. The left side of the
equation represents the compounded yield to investor who purchase a two year security,
while the right side of the equation represents the anticipated compounded yield from
purchasing a one year security and reinvesting the proceeds in a new one-year security at the
end of one year. If time t is today, t+1 r1 can be estimated by rearranging terms.

1 + t+1 r1 = (1 + ti2)2 / (1 + ti1)

t+1 r1 = (1 + ti2)2 / (1 + ti1) -1

The term t+1 r1 , referred to as the forward rate, is commonly estimated in order to
represent the market forecast of the future interest rate. As a numerical example, assume
that as of today (time t) the annualized 2 year interest rate is 10% while interest rate is 8%
the forward rate is estimated as follows:
Conceptually, this rate implies that one year from now, a one year interest rate must equal
about 12.037 % in order for consecutive investment in two one year securities to generate a
return similar to that of a two year investment. If the actual one year rate beginning one
year from now (at period t+1) is above 12.037%, the return from two consecutive one-year
investments will exceed the return on a two year investment.

The forward rate is sometimes used as an approximation of the market’s consensus interest
rate forecasts, because if the market had a different perception, demand and supply of
today’s existing two year and one year securities would adjust to capitalize on this
information. Of course there is no guarantee that the forward rate will forecast the future
interest with perfect accuracy.

If the term structure of interest rate is solely influenced by expectations of future

interest rate, the following relationship s hold:

Scenario Structure of yield curve Expectations about future Ir

t+1 r1> ti1 Upward Slope Higher than today’s rate

t+1 r1= ti1 Flat Same as today’s rate

t+1 r1< ti1 Downward Slope Lower than today’s rate.

Forward rates can be determined for various maturities. The previous examples can be
expanded to solve for other forward rates. The equality specified by the pure expectation
theory for three –year horizon.

(1 + ti3)3= (1 + ti1) (1 + t+1 r1) (1 + t+2 r1)

Where:

ti 3 = annualized rate on a three year security as of time t

t+2 r1=one-year interest rate that is anticipated as of time t+2 (2 years)

By rearranging the terms, we can isolate the forward rate of one year security beginning two years from
now:

1 + t+2 r1 = (1 + ti3)3 / (1 + ti1) (1 + t+1 r1)

t+2 r1 = (1 + ti3)3 / (1 + ti1) (1 + t+1 r1)-1

if the one year forward rate beginning one year from now(1 + ti1) has already been estimated this estimate
along with actual one-year and three year interest rate can be used to estimate the one year forward rate two
years from now. Recall that our previous example assumed ti1=8% and estimated t+1 r1 to be about 12.037%
illustration: assume that a three year security has an annualized interest rate of 11 % (ti3=11%)
given this information, the one year forward rate two years from now is:

t+2 r1 = (1 + ti3)3 / (1 + ti1) (1 + t+1 r1)-1

= (1 +.11)3 / (1 +.08) (1 +.12037)-1

= (1.367631/1.21)-1

=13.02736%

Thus the market anticipates a one-year interest rate of 13.02736% as of two years from now.

The yield curve can also be used to forecast annualized interest rates for periods other than
one year. For example, the information provided in the last example could be used to
determine the two- year forward rate beginning one year from now.

According to the pure expectations theory, one year investment followed by a two year
investment should offer the same annualized yield over three year horizon as three year
security that could be purchased today. This equality is as shown below.

(1 + ti3)3= (1 + ti1) (1 + t+1 r2)2

t+1 r2=annual interest rate of a two year security anticipated as of time t+1

By arranging terms t+1 r2 can be isolated:

(1 + t+1 r2)2 = (1 + ti3)3 / (1 + ti1)

Recall that today’s annualized yields for one year and three years securities are 8% and 11 %
respectively. With this information, t+1 r2 is estimated as follows:

(1 + t+1 r2)2 = (1 + ti3)3 / (1 + ti1)

= (1+.11)3/ (1+.08)

=1.266325

(1 + t+1 r2)2=√1.266325

=1.1253

=.1253

Thus the market anticipates an annualized interest of about 12.53% for two year securities
beginning one year from now.

Pure expectation theory is based on the premise that the forward rates are unbiased
estimators of future interest rates. If forward rate are biased, investors could attempt to
capitalize on the bias. As new information develops investors preference would change, yields
would adjust, and the implied forward rate would adjust as well.
LIQUIDITY PREMIUM THEORY

The Liquidity Premium Theory is an offshoot of the Pure Expectations Theory. The Liquidity
Premium Theory asserts that long-term interest rates not only reflect investors’
assumptions about future interest rates but also include a premium for holding long-term
bonds (investors prefer short term bonds to long term bonds), called the term premium or
the liquidity premium. This premium compensates investors for the added risk of having their
money tied up for a longer period, including the greater price uncertainty. Because of the
term premium, long-term bond yields tend to be higher than short-term yields, and the yield
curve slopes upward. Long term yields are also higher not just because of the liquidity
premium, but also because of the risk premium added by the risk of default from holding a
security over the long term. The market expectations hypothesis is combined with the
liquidity premium theory
(1 + ti2)2= (1 + ti1) (1 + t+1 r1) + LP2

Where: LP2 represents the liquidity premium on a two year security.

Market segmentation theory

This theory is also called the segmented market hypothesis. In this theory, financial
instruments of different terms are not substitutable. As a result, the supply and demand in
the markets for short-term and long-term instruments is determined largely independently.
Prospective investors decide in advance whether they need short-term or long-term
instruments. If investors prefer their portfolio to be liquid, they will prefer short-term
instruments to long-term instruments. Therefore, the market for short-term instruments
will receive a higher demand. Higher demand for the instrument implies higher prices and
lower yield. This explains the stylized fact that short-term yields are usually lower than
long-term yields. This theory explains the predominance of the normal yield curve shape.
However, because the supply and demand of the two markets are independent, this theory
fails to explain the observed fact that yields tend to move together (i.e., upward and
downward shifts in the curve).

Managing a Bond Portfolio.

For the casual observer, bond investing would appear to be as simple as buying the bond with
the highest yield. There are multiple options available when it comes to structuring a bond
portfolio, and each strategy comes with its own tradeoffs. The four principal strategies used
to manage bond portfolios are:

 Passive, or "buy and hold"

 Index matching, or "quasi passive"
 Immunization, or "quasi active"
 Dedicated and active
Passive Bond Strategy

The passive buy-and-hold investor is typically looking to maximize the income generating
properties of bonds. The premise of this strategy is that bonds are assumed to be safe,
predictable sources of income. Buy and hold involves purchasing individual bonds and holding
them to maturity. Cash flow from the bonds can be used to fund external income needs or
can be reinvested in the portfolio into other bonds or other asset classes. In a passive
strategy, there are no assumptions made as to the direction of future interest rates and any
changes in the current value of the bond due to shifts in the yield are not important.

The bond may be originally purchased at a premium or a discount, while assuming that full par
will be received upon maturity. The only variation in total return from the actual coupon
yield is the reinvestment of the coupons as they occur. On the surface, this may appear to
be a lazy style of investing, but in reality passive bond portfolios provide stable anchors in
rough financial storms. They minimize or eliminate transaction costs, and if originally
implemented during a period of relatively high interest rates, they have a decent chance of
outperforming active strategies.

One of the main reasons for their stability is the fact that passive strategies work best with
very high-quality, non-callable bonds like government or investment grade corporate
or municipal bonds. These types of bonds are well suited for a buy-and hold strategy as they
minimize the risk associated with changes in the income stream due to embedded options,
which are written into the bond's covenants at issue and stay with the bond for life.

Indexing Bond Strategy

Indexing is considered to be quasi-passive by design. The main objective of indexing a bond

portfolio is to provide a return and risk characteristic closely tied to the targeted index.
While this strategy carries some of the same characteristics of the passive buy-and-hold, it
has some flexibility. Just like tracking a specific stock market index, a bond portfolio can be
structured to mimic any published bond index. One common index mimicked by portfolio
managers is the Lehman Aggregate Bond Index.

Due to the size of this index, the strategy would work well with a large portfolio due to the
number of bonds required to replicate the index. One also needs to consider the transaction
costs associated with not only the original investment, but also the periodic rebalancing of
the portfolio to reflect changes in the index.

Immunization Bond Strategy

This strategy has the characteristics of both active and passive strategies. By definition,
pure immunization implies that a portfolio is invested for a defined return for a specific
period of time regardless of any outside influences, such as changes in interest rates.
Similar to indexing, the opportunity cost of using the immunization strategy is potentially
giving up the upside potential of an active strategy for the assurance that the portfolio will
achieve the intended desired return. As in the buy-and-hold strategy, by design the
instruments best suited for this strategy are high-grade bonds with remote possibilities
of default. In fact, the purest form of immunization would be to invest in a zero-coupon
bond and match the maturity of the bond to the date on which the cash flow is expected to
be needed. This eliminates any variability of return, positive or negative, associated with the
reinvestment of cash flows.

Duration, or the average life of a bond, is commonly used in immunization. It is a much more
accurate predictive measure of a bond's volatility than maturity. This strategy is commonly
used in the institutional investment environment by insurance companies, pension funds and
banks to match the time horizon of their future liabilities with structured cash flows. It is
one of the soundest strategies and can be used successfully by individuals. For example, just
like a pension fund would use an immunization to plan for cash flows upon an individual's
retirement, that same individual could build a dedicated portfolio for his or her own
retirement plan.

Active Bond Strategy

The goal of active management is maximizing total return. Along with the enhanced
opportunity for returns obviously comes increased risk. Some examples of active styles
include interest rate anticipation, timing, valuation and spread exploitation, and multiple
interest rate scenarios. The basic premise of all active strategies is that the investor is
willing to make bets on the future rather than settle with what a passive strategy can offer.

Conclusion
there are many strategies for investing in bonds that investors can employ. The buy-and-hold
approach appeals to investors who are looking for income and are not willing to make
predictions. The middle-of-the-road strategies include indexation and immunization, both of
which offer some security and predictability. Then there is the active world, which is not for
the casual investor. Each strategy has its place and when implemented correctly, can achieve
the goals for which it was intended.