The financial world had already gotten used to many long-held norms being upended after the 2008 financial crisis before the 2020 pandemic knocked even more things offsides. Among them: term premia, or the bonuses that investors traditionally received for the added risk of owning longer-term bonds. For most of the four years ending in December 2019, it’s been a term discount instead of a premium, which means the measure is negative. The gauge, which has historically been positive, went on a fresh slide when coronavirus fears sent investors racing for safety, driving long-term yields down to record levels.
1. What exactly is a term premium, anyway?
It’s the difference between what you get for locking up your money for an extended period and what you would get if you simply kept rolling over short-term instruments for the same amount of time. Many investors and analysts use the term premium on a Treasury note to help decide if it’s worth buying. By one Fed model, the term premium that 10-year Treasury bonds offer has averaged about 1.56 percentage points since 1961. It hit an all-time low of -1.299 percentage points in March.
2. Why reward holders of longer-term bonds?
The longer you lend money to someone (or, in this case, a government) for, the more time there is for things to go wrong. Former Fed boss Ben S. Bernanke says that in his analysis the term premium reflects the buffer that investors need to account for two key risks. One is changes in demand for or the supply of bonds, which can affect prices. The other is inflation, which would reduce the real value of future bond payments. When investors feel more uncertain on either point, they demand a higher premium.
3. How is that different from a yield curve?
Yield curves are a way of measuring the difference between what someone gets for investing their money for entirely different periods, say for two years versus 10 years. That gap includes the term premium along with other variables including a premium for liquidity that reflects how hard or easy it is to trade the securities.
4. What’s been going on with term premia?
Instead of longer-term debt providing extra yield for additional risk, there’s a discount. And it’s been that way for most of the time since late 2014.
5. Why is that?
In 2019, it had much to do with demand for Treasuries in a flight-to-safety amid the U.S.-China trade dispute. In 2020, there’s been an even biggerscramble for the security of Treasuries given fear of a steep global downturn in wake of the spread of the deadly coronavirus.
6. What’s driving the longer-term trend?
Fundamentally, you can mostly give blame to the Fed, and the intervention it has done in the past with bond markets known as quantitative easing, or QE. The U.S. central bank cut its key interest rate to near zero after the 2008 market meltdown. When the economy failed to revive, it began massive bond purchases with the goal of reducing longer-term rates. It also swapped short-term debt it held for longer-term debt, in what became known as Operation Twist. By one Fed estimate, the moves cut the term premium by 100 basis points on 10-year Treasury yield. And after spending some time shaving down its debt holdings a bit, the Fed last year began purchasing Treasury bills; after the pandemic’s spread roiled global markets, the Fed greatly expanded its buying of coupon-bearing notes across a range of maturities. These note and bond purchases aren’t a new round of QE, but were undertaken to support market functioning. The bill buying in 2019 was to combat a sharp spike in repo rates in September that caused turmoil in the money markets.
7. After the virus, will things go back to normal?
It doesn’t seem likely, at least at this time. Wall Street strategists project that the term premium will eventually rise, but not likely back to historical average. A possible upward force on term premia may come as the Treasury ramps up debt issuance to finance a fiscal shortfall that is ballooning due to the over $2 trillion government disaster relief package put in place to support workers and companies affected by the pandemic.
8. Why might it not rise more?
There seems no end in sight for now to demand for U.S. government debt. And an array of Fed support programs are lifting the Fed’s balance sheet, with it already having over over $6 trillion in assets. That’s well above the roughly $900 billion it held before the financial crisis. And similar debt purchases in Japan and Europe is keeping global debt yields low and demand relatively high for U.S. Treasuries.