The term premium is the compensation investors require for tying their money up in one long-term bond instead of buying short-term bonds one after another, reinvesting each as it matures, over an equal span of time. It is the part of a long-term yield that is not explained by expectations of future short-term interest rates. Because those expectations cannot be measured directly, the term premium cannot be observed in market prices and has to be estimated using statistical models.
The term premium is a central concept in the analysis of the yield curve, in monetary policy and in fixed-income investing. Changes in it explain much of the movement in long-term government bond yields that is not driven by changes in the expected path of policy rates.
Decomposing a long-term yield
A long-term yield can be split into two components:
Long-term yield = average expected short-term rate over the bond's life + term premium
If investors were indifferent between long and short bonds, the term premium would be zero and long yields would equal the average of expected future short rates, as the pure expectations hypothesis of the yield curve assumes. In practice, holding a long bond exposes the investor to the risk that interest rates rise and the bond's price falls before maturity, and to uncertainty about future inflation. Investors usually require compensation for these risks, so the term premium has historically tended to be positive.
Example
Suppose the 10-year US Treasury yield is 4.30%. A model estimates that investors expect the short-term policy rate, closely linked to the federal funds rate, to average 3.80% over the next ten years. The estimated term premium is 4.30% − 3.80% = 0.50%, or 50 basis points. If the 10-year yield rises to 4.60% while expectations for short rates are unchanged, the model attributes the whole 30-basis-point rise to a higher term premium.
Estimates rely on term-structure models that use the shape of the yield curve, and sometimes surveys of interest-rate forecasts, to infer expected future short rates. Widely cited US estimates include the model of Tobias Adrian, Richard Crump and Emanuel Moench (ACM), published by the Federal Reserve Bank of New York, and the Kim-Wright model maintained by staff of the Federal Reserve Board. Different models can give materially different levels, and estimates are revised as new data arrive, so the term premium is best treated as an approximate and model-dependent quantity.
- Interest-rate and inflation uncertainty: greater uncertainty about future inflation and policy raises the compensation required for duration risk.
- Supply of government debt: larger issuance of long-term bonds can push term premiums up.
- Central bank purchases: quantitative easing removes duration from the market and is generally estimated to have lowered term premiums.
- Demand for safe assets: strong demand from foreign reserve managers, pension funds and insurers can compress the premium.
- Hedging value: when bonds tend to rise in price as stocks fall, investors may accept a lower or even negative premium because bonds act as insurance in a portfolio.
Model estimates show the US 10-year term premium declining from high levels in the early 1980s, when inflation uncertainty was great, to around zero and at times negative values during much of the 2010s, a period of low inflation, large central bank bond purchases and heavy demand for safe assets. Estimates rose again after 2022 as inflation and government borrowing increased. A falling term premium can flatten the curve or contribute to an inverted yield curve even when markets do not expect sharp rate cuts, which complicates the use of curve inversion as a recession signal.
For central banks, the term premium affects how policy is transmitted to mortgage rates, corporate borrowing costs and other long-term rates. Policies such as asset purchases and yield curve control act partly by influencing it. For investors, it is the expected reward for bearing duration risk in Treasury bonds and other long-dated bonds instead of holding cash or Treasury bills. For governments, a higher term premium raises the cost of issuing long-term debt. Dealers and treasurers also see its effects in the pricing of interest rate swaps and in the spread between long rates and benchmarks such as SOFR.