What does Market Segmentation Theory state about bond interest rates?

Market Segmentation Theory posits that bond interest rates are determined by the supply and demand within specific maturity segments of the bond market. According to this theory, investors have distinct investment horizons—short-term versus long-term—leading them to prefer bonds that align with their investment preferences or risk tolerances.

Because of this segmentation, the interest rates for bonds in different maturities can be quite different and should be analyzed independently. Factors influencing interest rates for one segment may not apply to others, which is key to understanding this theory. Investors in the short-term market may react differently to economic conditions than those in the long-term market, leading to varying interest rates based on these distinct segments of time.

This distinction is crucial to bond pricing and investment strategies, as it illustrates how different market forces can create unique yield curves and interest rates that reflect specific conditions, rather than a uniform approach across all terms.