Couriosity 11.1: What Is the Term Structure of Interest Rates?
Bonds with identical risk, liquidity, and tax characteristics usually have different interest rates because of different times remaining to maturity. A graph of interest rates against times to maturity for identical bonds is called a yield curve; it describes the term structure of interest rates. Figure 11.4 provides an illustration based on the Treasury yield curve reported regularly in the ''Money & Investing" section of the Wall Street Journal. Yield curves almost always slope upward, showing that usually bonds with longer time to maturity pay higher interest rates (i.e., have higher yields to maturity). Why?
One reason may be that investors require a liquidity premium for taking on a longer maturity bond. A long-term bond involves more risk from interest-rate fluctuations that change its price much more than the price of a short-term bond. Another reason may be that people fear a resurgence of inflation at any time and require a premium for locking in their money at an interest rate that does not protect them from future unexpected inflation. A third reason, may be that long-term interest rate; embody expectations about what short-term interest rates will be between now and when the long-term bond matures. An upward-sloping curve therefore simply reflects expectations of higher short-term interest rates in the near future, perhaps because of higher expected inflation. Of course, people may expect that future inflation will be lower than current inflation, in which case the yield curve will be downward-sloping.
The yield curve is closely watched in financial sections of newspapers because of information it may provide regarding the direction in which the market expects short-term interest rates to more. A sharply upward-sloping curve, for example, often occurs after inflation has been brought down because people do not yet believe inflation's falls is permanent.
Another way of measuring this same phenomenon is the spread, the difference between the long- and short-term interest rates. For this purpose, the benchmark long-term interest rate is the 30-year T-bond rate, and the benchmark short-term interest rate is the 90-day T-bill rate.
Figure 11.4 Yield Curves The interest rate increases as time to maturity lengthens from three months to 30 years.
