Segmented market theory

Segmented market theory

After discussing the expectations hypothesis and the liquidity preference theory, we’ll now focus on the segmented market theory as another prominent theory of term structure. At its core, this theory posits that different segments or sectors of the bond market operate independently of each other, each driven by its unique supply and demand dynamics. Unlike the expectations hypothesis and the liquidity preference theory, which focus on a unified bond market, the segmented market theory acknowledges the existence of distinct investor preferences and institutional constraints that render segments of the market relatively isolated from one another. It is also referred to as the market segmentation theory.

Understanding the segmented market theory

One of the foundational concepts within the segmented market theory is the notion of preferred habitat. Investors are believed to have preferred maturity ranges based on factors such as investment horizon, risk tolerance, regulatory requirements, and market conventions. Consequently, they tend to concentrate their bond holdings within these preferred habitats, leading to segmented markets characterized by differential demand and supply dynamics across maturities. For this reason, an alternative name for the market segmentation theory is the preferred habitat theory.

In the extreme case, an investor whose preferred habitat is short-term bonds (say maturities up to 1 or 2 years) would never invest in long-term bonds. And, a long-term investor would never trade short-term bonds. So, there would be total segmentation across maturities and each region of the yield curve would be separate from one another.

More generally, the idea is that investors are typically reluctant to move across segments because doing so may not align with their investment strategies or risk tolerance. For example, a pension fund with long-term liabilities may prefer long-term bonds and may not shift to short-term bonds even if they offer higher yields temporarily.

Criticisms and limitations

One drawback of this theory is that it can’t explain why bond yields for different maturities tend to move with one another (e.g., in response to central banks’ monetary actions or international capital flows) over time.

In general, critics argue that the assumption of rigid segmentation is unrealistic, as some investors might indeed switch between maturities based on changes in interest rates or investment opportunities. The theory also may not fully account for arbitrage opportunities that can arise if there are significant interest rate differentials across segments.

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What is next?

We recommend the following papers for those interested in learning more about market segmentation in bond markets.

Kidwell and Koch (1983) “Market Segmentation and the Term Structure of Municipal Yields“, Journal of Money, Credit and Banking, Vol. 15(1), pp. 40-55.

Simon (1994) “Further evidence on segmentation in the treasury bill market“, Journal of Banking & Finance, Vol. 18(1), pp. 139-151.