Definition
Term structure of interest rates is the pattern of yields observed across bonds of different maturities at a given point in time, typically summarized visually by the yield curve.
Why it matters
The term structure is the foundational input to any calculation that discounts future cash flows to present value, because different points in the future are discounted at different rates. It is the observable rate structure from which discount curves for actuarial valuations, bond pricing, and lifetime income product pricing are derived.
How it works
The term structure captures the fact that a one-year bond and a thirty-year bond typically trade at different yields, and that the relationship between yield and maturity has structural features that vary with the interest rate environment. Under normal conditions, longer-maturity bonds carry higher yields to compensate holders for the additional time and the additional exposure to rate movements. Under stress or in specific policy regimes, the relationship can invert, with short-maturity yields exceeding long-maturity yields. The observed structure at any given moment is the composite of expectations about future short-term rates, a term premium that compensates for uncertainty about those expectations, and market segmentation effects reflecting the specific demand for bonds at each maturity.
In practice
For an individual evaluating a lifetime income arrangement, the term structure is what determines how the underwriting insurer converts the premium into a stream of promised payments. A steeper term structure raises the payout on longer-dated income promises because the insurer can invest premium proceeds in longer bonds at higher yields; a flatter or inverted term structure compresses these payouts. Ask a professional when a lifetime income quote was priced and what the term structure looked like on that date, because the same product will not price identically across different term structure environments and a quote from six months earlier may no longer be available at the same rate.
Related terms
- Yield curve
- Duration
- Convexity
- Present value
- Discount rate
- Real interest rate
- Nominal interest rate
- Term premium