Plenty of things that were taken for granted in the financial world before the crisis of 2008 no longer apply. Among the missing: the term premium, the bonus that investors traditionally received for the added risk of owning longer-term bonds. A number of Wall Street’s keenest observers think it may never return to historic averages, even though the Federal Reserve is reversing the steps that made it disappear from the U.S. bond market.
1. What exactly is a term premium, anyway?
It’s the difference between what you get for locking up your money for an extended period and what you would get if you simply kept rolling over short-term instruments for the same amount of time. By one Fed model, the term premium that 10-year Treasury bonds offer has averaged 1.61 percentage points since 1961. Many investors and analysts use the term premium on a Treasury note to help decide if it’s worth buying.
2. Why reward holders of longer-term bonds?
The longer you lend money to someone (or, in this case, a government), the more time there is for things to go wrong. Former Fed boss Ben S. Bernanke says that in his analysis the term premium reflects the buffer that investors need to account for two key risks. One is changes in demand for or the supply of bonds, which can affect prices. The other is inflation, which would reduce the real value of future bond payments. When investors feel more uncertain on either point, they demand a higher premium.
3. How is that different from a yield curve?
Yield curves are a way of measuring the difference between what someone gets for investing their money for entirely different periods, say for two years versus 10 years. That gap includes the term premium along with other variables including a premium for liquidity that reflects how hard or easy it is to trade the securities.
4. What’s going on with term premia right now?
It’s upside down. Instead of longer-term debt providing extra yield for additional risk, there’s a discount. And it’s been that way for most of the time since late 2014, with the figure falling as low as minus 76 basis points in July 2016.
5. Why is that?
Blame the Fed, and its intervention in the bond markets known as quantitative easing, or QE. The U.S. central bank cut its key interest rate to near zero after the 2008 market meltdown. When the economy failed to revive, it began massive bond purchases with the goal of reducing longer-term rates. It also swapped short-term debt it held for longer-term debt, in what became known as Operation Twist. By one Fed estimate, the moves cut the term premium by 100 basis points on 10-year Treasury yield. On top of that, the decision by other monetary authorities such as the Bank of Japan and the European Central Bank to slash their benchmarks to unprecedented lows means that U.S. debt is still relatively attractive, and the resulting global demand has added further downward pressure to the U.S. premium.
6. Where do strategists see the premium heading?
The Fed has begun "unwinding” its swollen balance sheet by reducing the amount of debt it reinvests as it matures. And with the U.S. economy recovering, it’s also in the process of slowly raising the interest rate it controls. The federal government’s budget deficit is also projected to start rising again, which means an increase in the amount of new bonds the Treasury Department will have to issue. That combination of factors means the term premium ought to rise.
7. So, things are going back to normal?
Not quite. Wall Street strategists are projecting the premium will rise by about half a percentage point, but that’s less than half of its decline from the historical average.
8. Why won’t it rise more?
Fed officials say it’s unlikely that their $4.5 trillion balance sheet will shrink all the way back to its pre-crisis level of roughly $900 billion. And those extraordinary monetary policies in Japan and Europe will keep foreigners coming back for U.S. debt. So long as that environment persists, interest rates and term premia are unlikely to climb back to their historical norms.
The Reference Shelf
- Former Fed Chairman Ben S. Bernanke’s blog on the term premium.
- The Federal Reserve Bank of New York’s term premium model.
- The Bank of International Settlements report on term premium.
- Bloomberg story on term premium model changes in post-QE era.
- The Fed’s report on how its asset purchases affected long-term rates.