The term structure of interest rates: evidence of market segmentation in the long end of the spectrum

Journal of the Academy of Business and Economics, Jan, 2003 by Aaron L. Phillips

ABSTRACT

One theory of the term structure of interest rates holds that markets are segmented by maturity, with each segment offering a yield resulting from the supply/demand equilibrium. Using data from United States Treasury constant maturity series, document significant bond market reactions to Treasury announcements of reduced supplies of 30-year bonds coupled with Treasury's debt buyback program. The results support the market segmentation theory. Supply-demand imbalances pushed bond prices up (and yields down) while the yield curve segment comprising 3-month through 5-year maturities displayed its characteristic upward-sloping shape.

1. INTRODUCTION

The term structure of interest rates is a fundamental concept in finance. Multiple theories have been proposed, yet research to date has failed to definitively explain the shape of the yield curve in the context of one of these proposed theories.

The market segmentation theory describes the yield curve as a set of maturity segments comprising participants with a business need for specific maturities. The shape of the yield curve, consequently, arises from the supply-demand equilibrium within each maturity segment. Under the segmented markets theory, participants in one segment would be indifferent to supply-demand forces in adjacent maturity segments. A variant of the segmented markets theory, the preferred habitat theory, allows for segment participants to be induced to leave their preferred habitat when there are sufficient incentives; i.e., higher yields. Empirical evidence generally supports the market segmentation theory at the short end of the yield curve (Mustafa and Rahman, 1995, Park and Switzer, 1997, Simon, 1991, and Taylor, 1992), but research is scarce for longer dated debt.

In early 2000 the United States Treasury (Treasury), responding to continuing budget surpluses, embarked on a new strategy of buying back older debt and limiting the amount of new 30-year bonds it would offer for sale. These actions represented a significant change in the expected supply quantity of long-term bonds. If the market segmentation theory holds, there should have been a market reaction to the reduction in the supply of long-term Treasury bonds and increased competition for the available bonds, causing yields to decline.

Using data from Treasury's constant maturity databases, the empirical evidence supports the market segmentation theory. Market participants responded three times to news on changing supplies of long-dated Treasury debt coupled with Treasury's repurchases of longer maturity Treasury debt. Market reactions took place first in November of 1999 following announcement of a new Treasury debt buyback plan and again in January and February of 2000 when a reduced supply of 30-year Treasury debt became evident and Treasury simultaneously inaugurated its debt buyback program. Due to Treasury's participation on the buy side and absence on the sell side, yields on long-term debt continued to under perform their forecast rates for a period of weeks in both instances while the short-term end of the yield curve continued to display its characteristic upward slope, thereby producing a dome-shaped yield curve.

2. UNITED STATES TREASURY AUCTIONS

The United States Treasury, as of 1998, had been a consistent net borrower for over thirty years. During this time interval, the U.S. federal budget had been continuously in a deficit situation. Beginning with the 1998 fiscal year (FY), however, the U.S. government began a series of annual budget surpluses. The 1998 FY surplus was $69 billion and rose to $123 billion in 1999. The expectation of continuing surpluses prompted a number of Treasury actions.

On August 4, 1999 Treasury announced a permanent reduction in its schedule of 30-year bond offerings. Instead of three times a year, Treasury kept the February and August offerings but eliminated November's offering. Treasury's recent experience had been to offer $10 billion of 30-year debt in each offering month. Also on August 4, Treasury indicated the opening of a sixty-day comment period regarding Treasury's proposed rule to allow it to buy back outstanding bonds.

Treasury's regularly scheduled debt refunding meeting took place on November 3, 1999. At that meeting, Treasury announced it was offering $25 billion of new debt to replace $29.3 billion that was coming due, but comprised of only 5-year and 10-year notes. Treasury further noted that in fiscal 1999 a net $88 billion of debt reduction took place and stated its intent to go forward with its debt buyback rule, although officials did not say whether or not buybacks would take place.

Any uncertainty surrounding Treasury's actual buyback rule implementation was eliminated January 13, 2000. That day Treasury Secretary Summers announced the beginning of its buyback program with a repurchase of as much as $30 billion in calendar 2000. Summers specified the targeted Treasury bonds for repurchase as "... debt that has substantial remaining maturity."