A:

Market segmentation theory states there is no relationship between the markets for bonds of different maturity lengths. MST holds that investors and borrowers have preferences for certain yields when they invest in fixed-income securities. These preferences lead to individual smaller markets subject to supply and demand forces unique to each market. MST seeks to explain the shape of the yield curve for fixed income securities of equal credit value. MST holds that bonds with different maturities are not interchangeable with each other. The yield curve is therefore shaped by the factors of supply and demand at each maturity length.

The yield curve is the relationship of the maturity to the bond yield mapped across different maturity lengths. The bond market pays close attention to the shape of the yield curve. There are three main shapes of the yield curve: normal, inverted and humped. A normal yield slopes upward slightly, with short-term rates lower than higher-term rates. A normal yield curve shows that investors expect the economy to keep growing. An inverted yield curve occurs when short-term interest rates are higher than long-term rates, and shows that investors expect the economy to slow down as central banks tighten the monetary supply. A humped yield curve shows mixed expectations about the future, and may be a shift from the normal to inverted yield curve.

According to MST, the demand and supply for bonds at each maturity level is based on the current interest rate and the future expectations for interest rates. The bond market is commonly divided into three main segments based on maturity lengths: short term, medium term and long term. The segmentation of the bond market is due to the fact that investors and borrowers are hedging the maturities of their assets and liabilities with bonds of similar time frames.

For example, the supply and demand for short-term government and corporate bonds depends on the business demand for short-term assets such as accounts receivable and inventories. The supply and demand for medium- and long-term maturity bonds depends on corporations financing larger capital improvements. Investors and borrowers seek to hedge their exposures at each maturity length, so the bond market segments operate independently of each other.

The preferred habitat theory is a related theory seeking to explain the shape of the yield curve. This theory states that bond investors have preferred maturity lengths. Investors will only look outside their preferred market if there is sufficient yield to compensate for the perceived additional risk or inconvenience of purchasing bonds with different maturity lengths. If the expected returns on longer-term bonds exceed the expectations for shorter-term bonds, investors that normally buy only short-term bonds will shift to longer maturities to realize increased returns.

RELATED FAQS
  1. What determines bond prices on the open market?

    Learn more about some of the factors that influence the valuation of bonds on the open market and why bond prices and yields ... Read Answer >>
Related Articles
  1. Investing

    Bond yield curve holds predictive powers

    This measure can shed light on future economic activity, inflation levels and interest rates.
  2. Investing

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  3. Investing

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  4. Investing

    Understanding the Different Types of Bond Yields

    Any investor, private or institutional, should be aware of the diverse types and calculations of bond yields before an actual investment.
  5. Investing

    Comparing Yield To Maturity And The Coupon Rate

    Investors base investing decisions and strategies on yield to maturity more so than coupon rates.
  6. Investing

    Find the Right Bond at the Right Time

    Learn about the types of bonds you should consider investing in, when you should be buying them and how to compare yields against their time to maturity.
  7. Investing

    Corporate Bonds: Advantages and Disadvantages

    Corporate bonds can provide compelling returns, even in low-yield environments. But they are not without risk.
  8. Investing

    Five Key Bond Moves to Profit from Rising Yields

    Here are five key moves to consider for structuring portfolios to profit from rising yields.
RELATED TERMS
  1. Preferred Habitat Theory

    The preferred habitat theory is a term structure theory suggesting ...
  2. Humped Yield Curve

    A humped yield curve is a relatively rare type of yield curve ...
  3. Yield Elbow

    A yield elbow is a point on the yield curve indicating the year ...
  4. Flat Yield Curve

    The flat yield curve is a yield curve in which there is little ...
  5. Biased Expectations Theory

    The biased expectations theory is a theory that the future value ...
  6. Curve Steepener Trade

    Curve steepener trade is a strategy that uses derivatives to ...
Trading Center