In a nutshell, market segmentation theory refers to the idea that the markets for bonds of different maturity lengths have no relationship with one another. Different demographics of customers who demand different lending and borrowing interest rates are attracted to each maturity length, and therefore, supply-and-demand forces affect each group individually.
Definition of market segmentation theory
Market segmentation theory, also referred to as the segmented markets 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.
The idea is that buyers of bonds with different maturities have different characteristics and investment goals. For example, insurance companies tend to buy long-term bonds in order to maximize income. On the other hand, banks tend to invest in short-term bonds in order to minimize volatility and protect their principal and liquidity.
In other words, we can't say that 10-year bonds always pay, say 1% lower yields than 15-year bonds. Each of these two maturities have completely separate supply-and-demand dynamics according to market segmentation theory, and this produces a separation between yields that tends to fluctuate over time.
For example, look at the chart below comparing two-year and five-year U.S. Treasury yields. Historically, there's usually a gap between the two yields, but the size of the gap has varied considerably over time.
This phenomenon results in a concept known as the yield curve.
The yield curve
The yield curve is a result of market segmentation theory, and is a line that plots the yields of bonds with equal credit ratings and different maturity dates. Typically, the yield curve compares the three-month, two-year, five-year, and 30-year U.S. Treasury debt.
There are three different shapes a yield curve can take:
- A normal yield curve shows that longer-term bonds have higher yields than shorter-term ones. This is a natural occurrence due to the increased default risk associated with longer investment time periods, and is a sign of an expanding economy.
- An inverted yield curve is one where the shorter-term yields are higher than the longer-term ones, and is generally considered to be a bad economic sign -- such as a predictor of a recession.
- A flat yield curve is one where the short- and long-term yields are almost identical. This is considered to be a sign of economic transition, either from a recession to an expansion, or vice versa.
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