Based on the current long-term interest rates, expectations theory aims to forecast how the short-term interest rates will change or behave in the future. According to the hypothesis, an investor would make the same amount of interest by purchasing two consecutive one-year bonds as opposed to one two-year bond today (Brigham & Houston, 2021). It seeks to assist investors in making choices based on projections of future interest rates. The theory predicts the rate for short-term bonds using long-term rates, often from government bonds (Brigham & Houston, 2021). Long-term rates can theoretically be used to predict what short-term bond rates will trade in the future. This argument contends that investors do not favor a particular maturity. All maturity periods for any of the securities are weighted equally.
According to the most recent data on the rates of maturity for US Treasuries, the rate is currently at 2.86% (Bloomberg, n.d.). The US treasuries are the government bonds that the US government issues to the public to raise money both in the short-term and long-term. The basis for raising this money is to aid the government in funding its expenditures (Brigham & Houston, 2021). Treasury bills, notes, and bonds make up US Treasuries. These securities are considered safe havens due to their low levels of default risk. They typically have short maturities, ranging from a few days to about 52 weeks (Brigham & Houston, 2021). The notes have different maturities depending on whether they have short-term or long-term maturity rates. They currently have maturity periods ranging from two to ten years, with investors receiving payments every six months. On the other hand, treasury bonds entail securities that often have extended maturities and are intended for long-term investors. They currently have maturities between 20 and 30 years, and they also pay interest to investors every six months.
The pure expectations theory indicates that the forward rates are objective predictors for formulating expectations of the future spot rates, which is what the pure expectations theory would suggest regarding this security. Based on the existing long-term interests, it forecasts future short-term interests. In applying the pure expectations theory to this security, this hypothesis would be supported by the present short-term and long-term yield rates, which are about 2.86% and 1.04% for long-term securities and short-term securities, respectively (Bloomberg, n.d.). The changes in these rates will help investors forecast the future behavior of the securities.
On the other hand, municipal bonds are those that have been issued by the state or local government. Both short-term and long-term municipal bonds now have different yields. The average yield for 30-year municipal bonds is currently 3.50%, while the average yield for short-term municipal bonds is currently 1.95% (FMS, n.d.). This also varies between short-term and long-term bonds in terms of maturity. The bonds’ maturity periods range from one year to thirty years. Therefore, the pure expectations theory would not hold in terms of what it would predict about the yield curve of this asset based on the current short- and long-term rates of municipal bonds. This is because long-term yield rates cannot be used to anticipate short-term interest rates with any degree of accuracy, which means that forward rates cannot be used to forecast future spot rates.
Corporate bonds are financial instruments that businesses issue to help them raise money to carry out their investment endeavors. Current yield rates for corporate bonds are 4.47% for short-term bonds and, on average, 6.52% for long-term bonds (Moody’s, 2022). These bonds currently come in short, medium, and long-term maturities. The current maturity for short-term bonds is less than three years; for medium-term bonds, it is four to ten years; and for long-term debts, it is greater than ten years. Based on the current short-term and long-term yields, the pure expectations theory would not hold in terms of what it would suggest about the yield curve. This is because the long-term and short-term yields do not correspond, making it impossible to use the long-term yield rates to predict the short-term rates in the future.
In terms of which securities to would hold, I would prefer municipal bonds. There are two factors I would consider and these are the returns and the level of risk. Municipal bonds have low-risk levels while also generating higher returns as compared to US treasuries. The current yearly default rate for municipal bonds is 0.03 % (FMS, n.d.). This indicates that these securities have a very low degree of risk when compared to Treasury bills and bonds. Additionally, Municipal bonds also provide a number of tax advantages over corporate bonds. Even though a corporate bond’s interest rate is probably higher, the investor will still owe taxes on it. Federal taxes are not applied to the majority of municipal bonds. Public-purpose municipal bond investment is likely to be free of alternative minimum tax. The majority of the time, local municipal bonds are free from state income taxes when an investor purchases them, which culminates in higher returns. I, therefore, see the justification for getting the most out of my decision to invest in municipal bonds on these bases.
Brigham, E. F., & Houston, J. F. (2021). Fundamentals of financial management. Cengage Learning.
Moody’s. (2022). Moody’s seasoned Aaa corporate bond yield. Web.
Bloomberg. (n.d.). US treasury yields. Web.
FMS. (n.d.). Municipal bond yields. Web.