Market Segmentation Theory

What is the 'Market Segmentation Theory'

Market segmentation theory is a fundamental theory regarding interest rates and yield curves, expressing the idea that there is no inherent relationship between the levels of short-term and long-term rates. According to market segmentation theory, the prevailing interest rates for short-term, intermediate-term and long-term bonds should be viewed separately, as items in different markets for debt securities.

BREAKING DOWN 'Market Segmentation Theory'

The major conclusion drawn from market segmentation theory and applied to investing is that yield curves are determined by supply and demand forces within each separate market, or category, of debt security maturities, and that the yields for one category of maturities cannot be used to predict the yields for securities within a different maturity market.

Market segmentation theory is also known as the segmented markets theory. It is based on the belief that the market for each segment of bond maturities is largely populated by investors with a particular preference for investing in securities within that maturity time frame – short-term, intermediate-term or long-term.

Market segmentation theory further asserts that the buyers and sellers who make up the market for short-term securities have different characteristics and investment motivations than the bulk of buyers and sellers of intermediate-term or long-term maturity securities, and they should not be considered interchangeable. The theory is partially based on the investment habits of different types of institutional investors, such as banks and insurance companies. Banks tend to favor investing in short-term securities, while insurance companies favor long-term securities.

A Reluctance to Change Categories

A closely related theory is preferred habitat theory. Preferred habitat theory is an extension of the belief that debt security investors have preferred lengths of maturity terms for bond investments, suggesting that most investors only shift from investing in securities of their preferred maturity length if they are offered substantial compensation for a making an investment choice that they perceive to involve additional risk. While there may not be an identifiable difference in market risk, an investor accustomed to investing in securities within a given maturity category nonetheless perceives a category shift as taking on additional risk because he is moving out of his traditional comfort zone in investments.

Implications for Market Analysis

Traditionally, the yield curve for bonds is drawn across all maturity length categories, reflecting a yield relationship between short-term and long-term interest rates. However, advocates of market segmentation theory, who believe that short-term rates have no direct or inherent effect on long-term rates, essentially suggest that examining a traditional yield curve covering all maturity lengths is a fruitless endeavor, because short-term rates are not predictive of long-term rates.