What it means
Lending money for one year does not cost the same as lending it for ten. Lenders need to be paid for the extra risk, uncertainty and lost flexibility that come with a longer commitment, so rates usually differ across maturities.
When long-term rates are higher than short-term rates, the curve slopes upward. This is the usual pattern, because investors demand more for tying up money for longer.
Sometimes the curve slopes downward, or inverts, with short rates above long rates. That has often been taken as a sign that the market expects rates to fall, which can happen when economic growth is expected to slow.
Businesses care because the term structure affects borrowing decisions. If long-term rates are only slightly higher than short-term rates, fixing the cost of a ten-year loan may look attractive, but if the gap is wide, a company might borrow short and accept the risk of refinancing.
The term structure is also the basis for valuing bonds and other future cash flows. Analysts use the rate for each maturity to discount (reduce to present value) payments that arrive at different times, which gives a more accurate result than using one rate for everything.
Theories exist to explain why curves take their shape. One view says the curve reflects expected future short-term rates, another says investors demand a premium for long bonds, and a third says different groups of investors prefer different maturities.
In practice, all three influences operate together.
In practice
Real-world examples.
Example
A property company is deciding whether to fix the rate on a $10,000,000 loan for five years or float. The treasurer reviews the yield curve and finds that fixed rates are only slightly higher than floating. She fixes the rate to protect the project's budget. She reviews the choice again if the curve moves materially before drawdown.
Example
An analyst at a fund manager notices that the yield curve has flattened over the quarter. She writes a note suggesting that growth expectations are weakening and recommends shorter-dated bonds. Her clients adjust their portfolios. Her note is circulated to the investment committee for discussion.
Example
A manufacturing company values a series of future lease payments. Instead of using a single discount rate, the finance team uses rates from the curve for each payment date. The present value is more precise and withstands audit questions. The auditors accept the approach because it follows market data.
Formula
Calculation
Implied forward rate f: (1 + two-year rate)^2 = (1 + one-year rate) x (1 + f)
The one-year rate is 3% and the two-year rate is 4%.
(1.04)^2 = 1.0816
1.0816 = 1.03 x (1 + f)
1 + f = 1.0816 / 1.03 = 1.0501
f = about 5.01%
This is the rate for the second year alone that is implied by the two rates, and it is higher than either because the curve slopes upward.Case study
Seen in the real world.
Ashgrove Estates is an illustrative, fictional developer that needed $20,000,000 to build apartments. The finance director saw that the yield curve was steep: short-term loans cost far less than long-term loans.
She chose a two-year floating loan for the construction phase and planned to refinance into a long-term fixed loan once the buildings were let. This saved interest during construction, but exposed the company to a risk that long rates might rise.
To manage that risk, she bought an interest rate hedge on part of the future loan. The illustrative lesson is that reading the term structure helps match the type of debt to the stage of a project. Ashgrove's board later asked for a quarterly update of the curve, so that the timing of the refinancing could be reviewed against market movements.
Watch out
Common mistakes.
- Assuming that long-term rates are always higher than short-term rates, when the curve can be flat or inverted. A flat or inverted curve is not unusual, and it has different implications for borrowing decisions.
- Using one interest rate to value cash flows that arrive years apart. Each cash flow should be discounted at the rate for its own maturity.
- Treating the shape of the curve as a certain forecast, when it reflects expectations and risk premiums that can be wrong. Curves can change quickly as expectations shift, so they should be refreshed before decisions are made.
Questions
People also ask.
What is a yield curve?
It is a chart of interest rates for different maturities, usually drawn for government bonds. Analysts often use the curve for government bonds as the benchmark because those bonds carry the least credit risk.
What does an inverted curve mean?
Short-term rates are higher than long-term rates, which the market has often associated with slower growth ahead. Investors and economists watch it closely, but an inverted curve is a warning sign rather than a guarantee.
Why does the term structure matter to a business?
It influences the cost of borrowing, the choice between fixed and floating debt, and the discount rates used in valuations. Understanding the shape helps managers decide when to borrow, how long to borrow for and how to value long-term contracts.
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