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  • Term premium is the extra compensation an investor seeks when holding longer maturity bonds. Term premium can be driven by many factors like inflation expectations, short-term interest rates and volatility.
  • Investors should look at term premium across fixed income assets. The reward is mainly the return from carry—the excess return for accepting some term premium in bonds.
  • In today's steep upward sloping environment there are globally carry return opportunities.

A bond investor is primarily concerned with the yield earned on a fixed income investment. The yield to maturity fluctuates because it resembles a sum of expectations that change frequently. These expectations range from what investors see as future inflation, where they expect short-term interest rates to be and what they think is the "term premium." This is the extra return investors demand for holding a longer maturity bond. According to the expectations hypothesis the "term premium" is the same as the expected return from rolling over a series of short maturity bonds with a total maturity equal to that of a long maturity bond. The term premium has been subject to significant academic and monetary policy debate about its true value. It has been difficult to estimate what term premium is and why it changes interest rates. For investors there are several practical ways how to think about term premium in a fixed income portfolio.

When analyzing bonds across the yield curve, investors look at what's called 'carry and roll down.' When the yield curve is upward sloping, it provides an opportunity to capture a roll down return. When investor buys a bond with for example a 5-year maturity, and the slope of the curve remains relatively the same, then in 1-year time the same bond has become a 4-year maturity. The positively sloped curve provides a positive price return because a 4-year maturity bond should have a lower yield than a 5-year maturity bond. The other return component is called "carry." This is the difference between the yield of a bond and the interest that can earned on holding cash. In an environment of near zero short-term rates, the carry of bonds can be high, even when the absolute level of interest rates is low. Combined the term premium therefore consists out of carry and roll down, all else being equal.

The further out in the future a fixed income investment matures, the greater the uncertainty how 'stable' its return. Factors that play a role are inflation that investors tend to be more worried about in a distant future. The reason is the less clear the trajectory of inflation, the less certainty there is about the path of short-term interest rates. The term premium has therefore been calculated as the difference between the yield of a bond minus the sum of inflation expectations and future short-term interest rates. There is an additional aspect of term premium which is liquidity. The liquidity preference theory says that short-term securities are less risky because they are highly liquid. Yield curves therefore have an invariably small, positively sloped "tail." At this part of the curve, investors would be willing to give up some return in exchange for the liquidity and safety of short-term securities.

Term premium is not only unique to US markets but exists also globally. There are two other factors that may influence the term premium, namely currency and international credit ratings. When there are upward sloping yield curves in other markets, the steepness of the slope may not be as evenly. The yield curve in Italy is for example much steeper than the yield curve in the US, while the yield curve in Mexico is flatter like in Japan. Turkey on the other hand has an inverted curve. There is rating difference between these countries that explains the difference in curve slopes. More importantly, each country's currency valuation is what investors may seek as excess return from investing local debt. The slope of the yield curve can therefore be upward and provide thereby term premium if a currency is relatively stable. When currency becomes distressed, a central bank may intervene by hiking short-term interest rates. In that case the term premium would be negative resulting from a flat to inverted yield curve.

Investors ought to be concerned with a certain level of term premium in bonds. However, any estimate of the term premium depends crucially on the markets' expectations of the future path of short-term interest rates, and these expectations are difficult to measure for long horizons. Albeit positive and high term premium may indicate greater uncertainty, an investor has to look at all aspects. The simplest way is to translate term premium into "carry" that encompasses returns from credit, duration, yield curve (roll down), volatility and currency.

Each of these has an impact on the term premium but most of all they can provide an opportunity for investors to diversify among different fixed income assets. Today's environment of near zero short-term interest rates that are carried by forward guidance, the slope of yield curve is likely to remain upward sloping for some time to come. For investors that means the term premium is a positive carry return opportunity. When applying a basic framework of the different carry components, an investor can select assets on the basis of total carry. When 'all stars align' the carry is at a maximum derived from valuation in credit, currency, volatility and curve. The term premium is therefore the risk-reward every investor should take in account.

Source: Terming Out The Premium