What does market segmentation theory assume about interest rates?

Market segmentation theory (MST) states there is no relationship between the markets for bonds with different maturity lengths and that interest rates affect the supply and demand of bonds. 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 and states 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 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 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. (For related reading, see "The Impact of an Inverted Yield Curve.")

According to MST, the demand and supply for bonds at each maturity level are 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 investors and borrowers hedging the maturities of their assets and liabilities with bonds of similar timeframes.

For example, the supply and demand for short-term government and corporate bonds depend 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 who normally buy only short-term bonds will shift to longer maturities to realize increased returns.

(For related reading, see Bond Basics Tutorial.)