Term Premium

The extra yield a lender demands for locking money up for years. It compensates for duration and uncertainty; it forecasts nothing. Confusing it with a rate expectation is a common error.

The extra yield

A long bond's yield is the average short rate the market expects over its life, plus a compensation for holding it. That compensation is the term premium. It is what an investor demands to give up the option of rolling short debt, and to bear the risk that rates and inflation move against them.

Compensation, not expectation

The term premium is not the market's forecast of where rates are going. It is the price of insurance against the unknown, and it moves with the supply of long bonds, with inflation uncertainty, and with the willingness of investors to hold duration. Investors who fear inflation demand more, and investors who need safe long assets accept less.

Because it is unobservable, it has to be estimated, and estimates differ. What is not in doubt is its direction of travel: more uncertainty or more issuance tends to raise it, and central bank purchases of long bonds tend to lower it.

Using it

The term premium is why long yields can rise even when the market expects the central bank to cut. If the compensation for holding duration grows, it can swamp a falling expected path.

One checkable use: when a long yield moves, ask whether the move is about the expected policy path or about the premium. A rise on unchanged expectations is a premium story, whether from fiscal risk, inflation uncertainty or supply, and it is the move that hurts long-duration portfolios most.

Related: Yield Curve · Quantitative Easing · Duration

Next: Real Interest Rate