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Term premium

The extra yield investors demand for holding a long bond instead of rolling short ones, over and above expected future short rates.

Three shapes of the yield curveNormal, flat and inverted curves plotted against how long a bond has left to run.One line is one day's picture of what bonds of each length pay.5%4%3%2%1%Yield (%)3 months2 years5 years10 years30 yearsTime until the bond maturesNORMALlong pays moreFLATmuch the sameINVERTEDshort pays more
Three shapes of the yield curve. The yield curve plots the interest a bond pays against how long you have to wait to get your money back. Normally longer bonds pay more; sometimes every maturity pays the same, and sometimes short bonds pay the most.

A 10-year yield can be split into two pieces: the average short rate the market expects over ten years, plus a premium for bearing the uncertainty of locking money up that long. The second piece is the term premium, and it cannot be observed directly, only modelled.

It matters because a rise in long yields means different things depending on which piece moved. Higher expected policy rates is a growth or inflation story. A higher term premium is a supply, uncertainty or demand story, and it tightens financial conditions without the fomc doing anything.

Example: the 10-year yields 4.35%. A model says expected average short rates are 3.95%, so the term premium is 40 bp. Heavy quarterly-refunding supply pushes the premium to 70 bp and the 10-year yield to 4.65% with no change in Fed expectations.

Related: expectations-hypothesis, forward-rate, quarterly-refunding, nominal-yield, yield-curve

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