Term premium

Term premium is the extra yield investors demand for holding a longer-maturity bond instead of repeatedly rolling over a series of shorter-term bonds to cover the same period. It compensates investors for the added uncertainty of locking in a fixed rate over a longer stretch of time, during which interest rates, inflation, and credit conditions could all move in ways that are impossible to predict today.

Term premium is one of the components economists use to explain the normal shape of the yield curve, where longer maturities usually offer higher yields than shorter ones. A yield curve can steepen because investors are demanding a larger term premium, reflecting greater uncertainty about the future path of rates, even if expectations for the average level of future short-term rates have not changed at all. Because term premium reflects investor psychology and risk appetite rather than a directly observable number, economists estimate it using statistical models rather than reading it directly off market prices.

A shrinking or even negative term premium has, at times, been cited as a factor behind an unusually flat or inverted yield curve, distinct from the more commonly cited explanation of investors expecting future rate cuts. Because term premium can be affected by factors like central bank bond purchases and shifting demand from large institutional buyers, its size can change for reasons that have little to do with the near-term economic outlook, part of why interpreting the yield curve requires some caution about assuming it only reflects future rate expectations.