Market Segmentation Theory
Bond markets provide bonds with short, medium, and long term maturity to engage investors with respective investment horizons. Market Segmentation theory tries to explain that such rates are independent of each other (they are not derivative of each other). Supply and demand of bonds guide the shape of the yield curve.
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How do market participants invest as per Market Segmentation Theory?
Bond markets have a larger share of institutional investors. Institutional investors have various maturity periods as per their regulatory requirements and types of funds under management. Pension funds, insurance funds have very large investment horizons which make them buyers of long term bonds. Banks invest in money market funds that invest in very short term bonds like (less than one year) due to liquidity and regulatory requirements. Investors are required to invest as per their investment horizons in order to balance their assets and liabilities. Long term investors stay invested for longer-term to capture extra returns (that come from bearing additional risks) and the cost of liabilities doesn’t change over the term. Hence, investors with different maturity transact in relevant maturity to maintain asset-liability balances & ensure no mismatch. The rationale of buying/selling as per own horizons shapes the yield curve paving way for rates to be independent of each other.
We can see the yield curve displayed here in the chart. This chart describes the term structure of interest rates. The yield curve in the chart is upward sloping which is based on the assumption of the economy continuing to progress and reflects longer-term incremental potential default risks. The yield curve can take upward sloping/inverse shape of uncertain shape as well. Inverse shape signifies declining confidence over the long term.
As we can observe in the above chart, 5-year treasury rates vary substantially from 2-year treasury rates over a period of time. The question arises what makes long term yield to pay extra returns issued by the same entity. Short term bond investors are not worried about material inflation risk & credit risk. Long term investors have to be worried about inflation risk which can reduce the value of the payout at maturity periods. Investors with a long horizon also stay exposed to credit risk (receiving full payments) & interest rate risk (which can be a source of price fluctuations).
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Brief Discussion about the shape of the yield curve as per Market Segmentation theory:
Hence, investors have unique preferences for their investments & they show reluctance to invest beyond their own preferred maturity for myriad reasons like regulatory constraints, capturing incremental yields, avoiding Asset-Liability mismatch. Such preferences shall decide the shape of the yield curve which will be independent of spot rates or any other risk premiums. Such investors provide supply and demand for securities of distinct maturities. The yield curve trajectory is guided by the supply & demand of such securities by investors.
Thus, bond markets face segmentation as per discrete maturity periods & corresponding set of investors. Their supply and demand influence the yield curve.
Author: Ashutosh Buch
About the Author:
Ashutosh Buch is CFP (FPSB India) & has passed Level-I of CFA Program. His primary interest lies in analyzing investments in primary & secondary markets. At present, he focuses on learning the nuances of financial markets & management consulting. He remains committed to his goal of helping businesses scale up & making them ESG-friendly.