Bonds, Mutual Funds, & Exchange-Traded Funds
David Goodman(Nov 7, 2018 6:37 PM)- Read by: 1
This week we are choosing one of three theories to discuss and I have selected to go with the Market Segmentation Theory.
According to our text, “the market segmentation theory suggests that the market for debt is segmented on the basis of the maturity preferences of different financial institutions and investors.” In other words, the yield curves are determined by the supply and demand within each maturity segment of the market. This theory is based on the belief that bond maturities consists primarily of investors investing for specific durations. The theory takes into account the investments habits or strategies of various institutional investors, whether that is short term or long term securities. One thing to note, this theory is sometimes referred to as the segmented markets theory.
When talking specifically about the theory’s effect on the yield curve, under the market segmentation theory, the yield curve changes as the supply and demand for the funds determines the prevailing interest rates whether we are talking about short term maturities or long term maturities. It is the relationship between rates that will determine whether the shape of the yield curve is upward or downward sloping. In order to see a downward sloping yield curve under this theory, we need to have an excess demand of short term borrowing with an excess supply of long term funds. With the market segmentation theory comes the thought that examining a traditional yield curve that covers all maturities is a bit of a waste. The reason being that short term rates are not predictive of long term rates.
During my research I came across the Motley Fool’s page defining the market segmentation theory and the following piece from them really took hold, “Market segmentation theory,..., says that bonds of different maturities effectively trade in different markets, each with its own supply-and-demand forces that produce bond yields. Because of this, the yields from one group of bonds with a certain maturity length cannot be used to predict the yields of another group.”
When thinking about the three theories and which is the most valid of them, I lean towards the market segmentation theory. One thing that sticks out the most to me from the text reading, is that the expectations hypothesis is based on investor’s expectations on how interest rates will change in the future. An expectation, while based on some interrupted data, is still just a guess at the end of the day. For this reason I ruled out the expectation hypothesis. Liquidity preference theory was a bit harder to rule out and I honestly do not have a good argument here other than the market segmentation theory makes more sense to me with its stated relationships.
References
Smart, S. B., Gitman, L. J., & Joehnk, M. D. (2017). Fundamentals of investing. Pearson Education.
Staff, I. (2018, August 20). Market Segmentation Theory. Retrieved from https://www.investopedia.com/terms/m/market-segmentation-theory.asp
Staff, M. F. (2017, April 06). What Is Market Segmentation Theory? Retrieved from https://www.fool.com/knowledge-center/what-is-market-segmentation-theory.aspx
2. RESPOND TO MATTHEW PLEASANTS
Matthew Pleasants(Nov 7, 2018 3:30 PM)- Read by: 2
The market segmentation theory is one of the more modern theories that deals with interest rates and for summary states that a relationship is not necessary between the long term or short-term interest rates. Investors have a fixed maturity.
What the market segmentation theory is trying to piece together the relation between the yield of debt and the maturity period. It explains the reasons behind the normal yield curves over the other forms of yield curves. The short term and long term are separated into different categories, but the yield curve shape will be affected by the supply and demand for the securities associated with the maturity length.
The market segmentation theory notices that some investors prefer the short-term market but there are some investors who still prefer the long-term market. Within the market segmentation theory states if a short-term rate experiences an increase for any amount of time, investors will not go from long term to short term bonds just, so they can take advantage of the higher rate of return with the short-term bonds. Even with a short-term bond run will increase the interest but it does not have a big impact on the interest of switching from long-term bonds.
The market segmentation theory was based off the practices of institutions that are followed by commercial banks, investment trusts, and insurance companies. No theory can avoid issues, and such there is some overlapping that occurs between the markets.
The other two theories for a quick summary are:
1. The expectations theory states that rising short-term interest rates create the positive yield curve and the opposite for a negative yield curve. For example, if there is a two-year rate higher than a one year, that rate should increase. When a curve is flat the market can expect short-term rates to be low or constant in the future. With a declining rate-term structure means that the market is indicating the rate will decline.
2. The liquidity theory states investors prefer higher levels of liquidity when dealing with short-term debt and any deviance from the positive yield curve is only a temporary phenomenon.
The conditions that would result in a downward-sloping yield curve is a recession unlike the conditions that would cause an upward-sloping yield is a period of economic expansion. All three theories have their own place within investment world.
Reference
“Market Segmentation Theory - Meaning, Overview, Facts.” World Finance, www.eiiff.com/finance-theory/yield-curve/market-segmentation-theory.