Long-term government bond yields reflect two components: the market's expectation of future short-term interest rates and the term premium, the extra yield investors demand for holding longer-duration, interest-rate-sensitive securities rather than rolling short-term bonds. This premium compensates for exposure to interest-rate volatility, inflation uncertainty, and liquidity or credit concerns. Glenn D. Rudebusch of the Federal Reserve Bank of San Francisco discusses how these risk and liquidity considerations shape the premium and therefore move long yields independently of rate expectations.
How the term premium works
When investors fear larger swings in policy rates or inflation over the life of a bond, they require higher compensation up front. Conversely, in periods of abundant demand for safe, long-dated assets—driven by aging populations, regulatory demand for high-quality collateral, or central bank purchases—the term premium can fall, pushing long yields below what expected short rates alone would imply. John H. Cochrane at Stanford Graduate School of Business frames the premium as a function of investor risk aversion and macroeconomic uncertainty, emphasizing that it is not directly observable but inferred from models of the yield curve.
Causes and consequences
Changes in monetary policy stance and forward guidance affect expected short rates, but they can also influence the term premium through signaling and balance-sheet operations. Quantitative easing that purchases long bonds tends to compress the premium by reducing available duration risk in private portfolios, which lowers borrowing costs for households and governments. A lower term premium directly reduces mortgage and corporate borrowing rates, supporting consumption and investment. However, persistent suppression of the premium can also encourage risk-taking and distort savings returns, with territorial differences: emerging markets often face higher premia due to sovereign risk and lower liquidity, while advanced economies with deep safe-asset markets typically exhibit smaller premia.
Because the term premium is a key channel linking policy, markets, and the real economy, central banks and fiscal authorities monitor it alongside expectations of future rates. Understanding its drivers helps explain why long yields sometimes move contrary to short-rate expectations and why identical policy paths can produce different financing costs across countries and over time.