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The term structure of interest rates describes the relationship between long- and short-term rates. The term structure is important to corporate treasurers who must decide whether to borrow by issuing long- or short-term debt and to investors who must decide whether to buy long- or short-term bonds. Thus, it is important to understand (1) how long- and short-term rates relate to each other and (2) what causes shifts in their relative positions.

Interest rates for bonds with different maturities can be found in a variety of publications, including The Wall Street Journal and the Federal Reserve Bulletin, and on a number of web sites, including Bloomberg, Yahoo, and CNN Financial. From interest rate data obtained from these sources, we can construct the term structure at a given point in time. For example, the tabular section below Figure 1-6 presents interest rates for different maturities on three different dates. The set of data for a given date, when plotted on a graph such as that in Figure 1-6, is called the yield curve for that date.

The yield curve changes both in position and in slope over time. In March 1980, all rates were relatively high, and since short-term rates were higher than long-term rates, the yield curve was downward sloping. In October 2001, all rates had fallen, and because short-term rates were lower than long-term rates, the yield curve was upward sloping. In February 2000, the yield curve was humped—medium-term rates were higher than both short- and long-term rates.

Figure 1-6 shows yield curves for U.S. Treasury securities, but we could have constructed curves for corporate bonds issued by Exxon Mobil, IBM, Delta Air Lines, or any other company that borrows money over a range of maturities. Had weconstructed corporate curves and plotted them on Figure 1-6, they would have been above those for Treasury securities because corporate yields include default risk premiums.However, the corporate yield curves would have had the same general shape as the Treasury curves. Also, the riskier the corporation, the higher its yield curve, so Delta Airlines, which has a lower bond rating than either Exxon Mobil or IBM, would have a higher yield curve than those of Exxon Mobil and IBM.
Historically, in most years long-term rates have been ab

ove short-term rates, so the yield curve usually slopes upward. For this reason, people often call an upwardsloping yield curve a “normal” yield curve and a yield curve that slopes downward an inverted, or “abnormal,” curve. Thus, in Figure 1-6 the yield curve for March
1980 was inverted and the one for October 2001 was normal. However, the February 2000 curve is humped, which means that interest rates on medium-term maturities are higher than rates on both short- and long-term maturities.We explain in detail in the next section why an upward slope is the normal situation, but brie?y, the reason is that short-term securities have less interest rate risk than longer-term securities, hence smaller MRPs. Therefore, short-term rates are normally lower than long-term rates.

What is a yield curve, and what information would you need to draw this curve?
Explain the shapes of a “normal” yield curve, an “abnormal” curve, and a “humped” curve.

Taken From : Five-Minute MBA – Corporate Finance

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