Term Premium
The Term Premium is the extra yield that investors demand for holding a longer-maturity bond compared to rolling over a series of shorter-maturity bonds expected to produce the same average return, compensating for the additional uncertainty and interest rate risk inherent in longer-duration fixed income securities.
The yield curve — the relationship between bond maturities and their yields — is normally upward sloping, meaning longer-term bonds yield more than shorter-term ones. This slope can arise from two sources: expectations of future short-term rates (if investors expect rates to be higher in the future, long yields should be higher than current short yields) and the term premium. Decomposing the yield curve into these two components is one of the central empirical challenges in fixed income economics.
The term premium compensates investors for multiple sources of uncertainty in holding long-term bonds. Interest rate risk is the most direct: if you hold a 10-year Treasury bond and interest rates rise after purchase, the market value of your bond falls. You are locked into a lower coupon while new bonds offer higher yields. The longer the maturity, the more sensitive bond prices are to interest rate changes (measured by duration), so investors rationally demand a higher yield to accept this risk.
Inflation uncertainty is a second component of the term premium. The purchasing power of a fixed nominal payment 10 or 30 years in the future depends on what inflation does over that horizon — an inherently uncertain outcome. Investors require compensation for the risk that realized inflation may be higher than expected, eroding the real return on their fixed nominal cash flows.
Liquidity risk and supply-demand dynamics also influence the term premium. During periods when the Fed was buying large amounts of long-dated Treasuries through QE programs, the term premium was compressed as the largest price-insensitive buyer artificially reduced the yield premium for long bonds. As the Fed reduced its Treasury holdings through QT, the term premium expanded, contributing to rising long-term yields even when short-term rate expectations were stable.
The ACM model (Adrian, Crump, and Moench) published by the New York Fed is the most widely cited academic estimate of the US Treasury term premium. In the early 2020s, the 10-year term premium was estimated to be near zero or even slightly negative — reflecting QE impacts and strong demand for safe assets from insurance companies and pension funds. The 2022-2023 period saw the term premium rise meaningfully, contributing to the sharp increase in long-term Treasury yields that rattled equity valuations.