Economic and Market Commentary

Why the Term Premium Matters for Bond Investors

11/06/2024

Richard Clarida, Allison Boxer

A timely discussion on the term premium, which may be signaling the possibility of rising compensation for bond investors as the yield curve potentially re-steepens.

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ALLISON BOXER: Text on screen: Allison Boxer, Economist

Rich, let me bring you in on this as well, just from an interest rate perspective. You of course authored something earlier this year about the term premium. Yeah, so we'll just, you know, get your thoughts on the fiscal situation that Libby outlined and how investors should be thinking about it from a rates market perspective.

RICHARD CLARIDA: Text on screen: Richard Clarida, Global Economic Advisor

Sure. And what, first of all, what is the term premium? It's easier to describe than measure, but it's the compensation that bond investors earn for taking on interest rate risk. So in general, if you take on risk, you want to be paid for it. And historically, bond investors have been paid in a term premium with a higher return and say a ten year treasury than a T bill. And in particular, term premiums are driven by a lot of factors, including global developments and the like. But, one factor is debt and deficits. And I think what we have argued here and what we're starting to see in the data and I made reference to this in the piece that you mentioned is, you know, markets aren't blind to this. Markets have already started to price in, we believe, a term premium, whether or not looking at real yields on inflation index bonds or other indications.

A lot of the repricing that we have seen in the last couple of years, remember ten year treasury yields got down below 1% at one point. And so, yes, it's been a big move up, but really what was abnormal was the 1%, 10 year treasury yield, not the four point a half percent treasury yield that we see now. So, we do think and this is a core thesis of ours, that going forward, you know, bond investors will earn that term premium and in particular as the yield curve gets steeper. And so we are in a very unusual period now where we have had this inverted yield curve for going on two years. That's not the new normal. The curve will not be inverted forever. It will re-steepen. And when it does, that's going to be a positive for bond investors as well.

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