Interest rates: A closer look at maturity

Maturity effect: lenders want higher rates if the length of the loan is longer.

Would you lend out money for 3 months and 30 years at the same rate? If you would, you would certainly be in the minority since most lenders demand a higher return on funds lent for longer periods of time because they feel the risk of the loan rises with the length of the loan.  The maturity effect can be seen in Diagram 1. Throughout most of the post WW II era, the rate on short-term government debt (three-month US government securities) was lower than the rate on long-term debt (ten-year US government bonds).  It was also more volatile.  For more recent information you could check out some current real-world data from world and US markets. 

Diagram 1

A second way to demonstrate the maturity effect is the term-structure of interest rates evident in the yield curve, a graph of the relationship between yield (rate of return = interest rate) and maturity.  What you would tend to find is a relationship similar to the upward sloping line in Diagram 2 based on average annual rates for the period 1980-1995. The upward slope clearly indicates the market charges a premium for time - the longer the length of time the higher the interest rate.  The average rate on 6-month (G-6M) borrowing was approximately 7.5 percent, while the rate on 30-year (G-30Y) borrowing was close to 9.5 percent.

Diagram 2

One thing you will find, however, is the yield curve moves around quite a bit as you can see in Diagram 3 below.  Rates in the 1980s are clearly above rates in the earlier years, while rates in the 1960s are clearly below those in the following years.

Diagram 3

How do we explain the rather dramatic shifts in the yield curve? If you return to our earlier discussion of interest rates, you will realize that the obvious place to start would be inflation. If we adjust the annual interest rates for the annual inflation rates to obtain real rates and plot the term-structure of real rates we get the graph below. What we find is the real interest rates were exceptionally high in the 1980s and exceptionally low in the 1970s, although the structure tends to be similar. What we appear to be seeing again is a capital market adjusting slowly to rising inflation rates in the 1970s and to falling interest rates in the 1980s.

Diagram 24

If we combine these two exceptional periods we find that the dramatic variations in the term-structure of real rates disappears in the 1990s. What we do find in the first half of this decade is that the maturity premium is exceptionally high by historical standards.  Now it's time to move on, but if you are interested, you can check out a more detailed discussion of the yield curve.