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.
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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.
Two-Year Treasury Rate data by YCharts.
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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What is Market Segmentation Theory?
The market segmentation theory is the assumption that both short-term and long-term interest rates have no correlation whatsoever. In addition, the theory states that the interest rates for each different maturity segment vary. Note that this depends on demand and supply as well as demand and risk related to security.
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How Does Market Segmentation Theory Work?
According to this theory, behaviors are analyzed separately. This, therefore, means that a change in one behavior does not in any way cause the other to change. Basically, market segmentation theory assumes that each of the bond maturities market segments is mainly made of investors, who, in this case, prefer to invest in securities that have specific durations such as short-term, long-term or intermediate. In addition, the theory asserts that buyers and sellers who make up short-term securities market have distinct features and motivations compared to buyers and sellers of long-term as well as intermediate maturity securities. The theory partly applies to various types of institutional investors and their investment behaviors. Such institutions include insurance and banking institutions. Note that when it comes to securities, banks prefer investing in short-term securities while insurance institutions prefer to invest in securities that are long-term. Generally, when it comes to investing in fixed-income securities, this theory holds that there is a preference for particular yields among borrowers and investors. It is this preference that causes the smaller markets each to have supply and demand that is unique to each other. Since each yield is as a result of factors related to demand and supply depending on each maturity length, it makes bonds with different maturities not be interchangeable.
History Behind Market Segmentation Theory
Market segmentation theory was first introduced in 1957 by John Mathew Culbertson an American economist. Culbertson wrote the paper known as, The Term Structure of Interest Rates, where he disagreed with Irving Fishers term structures model-driven expectations, which prompted him to come up with his own theory to explain how the market sets a price on fixed income securities.
Market Segmentation Theory vs. Preferred Habitat Theory
Preferred habitat theory is a theory that tells more about market segmentation theory. For instance, the preferred habitat theory argues that investors that have a preference on bonds with different range of maturity lengths, usually change their preferences when they are certain that by shifting, they will in return get higher yields.
Key Takeaways
- The market segmentation theory is the assumption that both short-term and long-term interest rates have no correlation whatsoever.
- Market segmentation theory was first introduced back in 1957, by John Mathew Culbertson an American economist.
- Preferred habitat theory is a theory that tells more about market segmentation theory.