Extra yield investors demand for holding longer maturities instead of repeatedly rolling short-term instruments.
Term premium is the extra yield investors demand for holding a longer-maturity bond instead of repeatedly rolling over shorter-term instruments. It is one of the main reasons a normal yield curve often slopes upward.
Term premium matters because long-term yields are not just averages of expected future short rates. They also include compensation for:
| Component | What it means | Why it matters |
|---|---|---|
| Expected future short rates | Market view of where short rates may go over time | Explains the policy-path part of long yields |
| Term premium | Extra compensation for locking money up longer | Explains why long yields can sit above those expected short rates |
At a high level:
If the term premium rises, long-maturity yields can climb even when the expected policy path does not change much. If the term premium falls, long yields can drop even without a major shift in rate-cut expectations.
That makes term premium important for:
Suppose the market thinks the average expected short-rate path over ten years is about 3.8%, but the 10-year Treasury yield is 4.3%. One rough interpretation is that about 0.5%, or 50 basis points, reflects term premium and other long-horizon compensation.
Term premium compensates for maturity-related uncertainty. Credit spread compensates for issuer and benchmark risk differences.
When investors strongly prefer long-term safe assets, long yields can sit below what a simple expectations-only story would suggest.