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Market segmentation theory states that markets for debt securities with different maturity periods are mutually exclusive. It also hinges on the idea that long- and short-term interest rates are not related to one another for the reason that their investors differ.
Within that, the theory also suggests that yield curves are determined largely through assessing supply and demand forces in each market or category of debt security maturities. It posits that any yield from a single category of maturities cannot be utilized for yield prediction across differing categories of maturity.
It forwards that interest rates for debt securities with short-term periods and those with long-term periods are independent of each other. Thus, both should be calculated within their respective segments instead.
Debt securities represent a portion of the debt issued by private corporations, governments, and governmental agencies. Essentially, an organization issues a debt instrument to obtain capital. An example to consider is bonds.
When buying a bond, the buyer essentially becomes an investor and lends money to the issuer. The issuer, on the other hand, pays a specified interest rate during the life of the bond and pays back the buyer the principal amount of the bond, plus interest, upon its maturity date.
Market Segmentation Theory: Investors Choice
Relevant to market segmentation theory is the concept of ‘investors choice’. Investors prefer a high amount of liquidity. They prefer that their investments can easily be converted to cash. True to this, they normally invest in debt securities with short-term periods.
This is the case for commercial banks. Commercial banks favor short-term investments because they need to maintain the liquidity of their assets. Short-term investments are also exposed to lower risks and can have a reasonable expectation of return compared.
However, when the demand for short-term investments increases, the higher the interest rates become. When interest rates increase, the higher the price of bonds will be.
While there is a certain assurance of liquidity for short-term investments, the yield can stay at a low rate. This usually happens when the economy experiences a period of inflation. Inflation sees a decrease in the purchasing power of consumers, which is a risk for investors receiving a fixed rate of interest.
Nevertheless, fluctuations in the exchange rates of short-term securities will not affect the stability of long-term investments. This is why investors in long-term investments typically refrain from shifting. As their investments stay longer in the market, they earn much higher returns in aggregate and over time.
Insurance companies can take the risk of investing in debt securities for a long-term period. This is because they assume a more stable market position. The reason for this is that the sum of payments they make to their policyholders over any given period can be calculated beforehand with reasonable accuracy.
Additionally, policyholders are also required to continue paying premiums even during economic declines. As a result of this, insurance companies have a steady cash flow to rely on. With stable projected costs and earnings, insurance companies are much more predisposed to engage in higher-risk investments, such as those with a longer-term period.
Aside from interest rate risks, the bond price is also determined by credit risk. Credit risk refers to the risk involving the liquidity of the bond issuer. In other words, it is the probability that the bond issuer will not be able to make the payments of the interest or the principal amount as scheduled. The higher the probability of failure to pay, the higher the risk is assumed by the buyer. This results in the higher price of a bond.
This is why corporate bonds are issued at a higher price and have a higher risk. Corporations have a higher risk of defaulting—or failing to pay—compared to the government, which can issue bonds with the full faith and credit of the state.
Bond Yield Curve
Yield is the return that is earned on a bond based on the price paid and interest payments received. A yield curve shows a graphical representation of yields on bonds similar to a variety of maturities—these are also called structure of interest rates.
The most common way to measure a bond’s yield is yield to maturity. This is the total return an investor will receive from holding a bond until it matures, including all the interest received. This also includes any gain or loss if the bond was purchased at variance to its par value. Moreover, a bond price fluctuates as it reaches maturity, and this will inversely affect its yield.
A yield curve shows the yield of bonds having equal credit quality, or interest rates, but with different maturity lengths. This is normally used to predict changes in economic output and growth. However, proponents of the market segmentation theory advise against it because interest rates of bonds with a short-term period do not reflect those with a long-term period.
It is impossible to predict future interest rate outcomes based on short-term interest rates. Furthermore, long-term interest rates are mere expectations and do not indicate a definite outcome.
Preferred Habitat Theory
Market segmentation theory also assumes that investors have different expectations and interests. They enter the market that matches their ability to invest and to take risks. This is called the preferred habitat theory.
Developed following the Nixon era—the preferred habitat theory arose from having to meet the difficulties presented by fiat currency systems. It is a variant of the market segmentation theory and to date, it is an indispensable tool.
There are conclusions that the preferred habitat theory follows. These underscore theories on how rates might go up but how they might also remain the same, with the upward slope to mirror the risk premium. This means that fundamental conditions are likely to continue under the condition that the economy is growing.
In most cases, investors don’t switch markets as the change inherently brings higher risks. They only do so when there is more assurance of a substantially higher yield, which can compensate for the risk they would take. The preferred habitat theory suggests that even though investors might prefer a certain segment of the market in their transactions and risk, they are often prepared to veer away from this desired segment if they believe that they would be adequately compensated later on for making that decision.