Back to the Future: Term Premium Poised to Rise Again, With Widespread Asset Price Implications

This PIMCO Perspectives assesses how the term premium’s 40-year downturn could start to reverse.

Common sense holds that investors should get paid more for taking more risk. This tends to be true in the bond market: The further you extend the maturity of bonds you hold, the more uncertainty you are underwriting and the more you should get compensated. Think about it simply. If you own a two-year bond, your principal will be returned after two years (absent default) and you can decide how to reinvest. The problem with a 30-year bond is that after two years, you still have to wait another 28.

Currently, the U.S. bond market doesn’t follow this logic. The yield curve is inverted, with cash yielding more than longer-dated bonds. The odds are that this trend will not continue.

The most common way an inversion corrects is when the Federal Reserve cuts its short-term policy rate, which both markets and Fed officials expect to happen this year. However, there is the possibility of a much bigger shift ahead: that the curve will also correct as the term premium comes back.

Since the financial crisis, the term premium – a gauge of how much more it pays to hold longer-dated debt instead of repeatedly reinvesting in short maturities – has averaged only about 50 basis points (bps), even turning negative at times (see Figure 1). But what if we are heading back to the future, to a market resembling prior decades when higher term premiums prevailed?

The 10 Year term premium has been in decline since the 1980s