The impact of the term premium on rates

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

All data referenced in this article are sourced from Bloomberg unless otherwise stated, and is accurate at the time of publishing.

Key points

• The rate market remains volatile, with lower, but slower, trending inflation prompting investors to price in fewer cuts this year than previously expected
• Apart from the US Federal Reserve policy rate path term premium, the premium to hold longer bonds is likely to impact bond yields in coming months
• As the US election approaches and with existing high debt levels, the term premium could again exert significant influence 
• While higher term premium can lead to higher yields, it appears more likely to be temporary in nature. In addition, a higher premium does not always translate into higher bond yields. As such, higher term premium might be used to extend duration

The rate market remains volatile and term premium at the long end of the yield curve could cause further volatility. However, higher term premium should not always be associated with higher yields. 

The drivers of rate sell-offs

Historically, various factors initiated and contributed to rate sell-offs. The front end of the yield curve seems to be the biggest driver typically, as witnessed between September 2021 and October 2022: US 10-year yields surged from around 1.3% to 4.3% (+300 basis points, bp) primarily driven by higher US 2-year yields (+400bp).

By contrast, the rate sell-off witnessed during the third quarter of 2023 was less driven by the short end but by the long end of the curve: the US 10-year yield rose from 3.7% to just above 5% in between July and October. Global bond investors attributed the move to the rise of the so-called term premium. 

According to prior US central bank president Ben Bernanke the term premium is the extra return that lenders demand to hold a longer-term bond instead of investing in a series of short term-term securities (for instance, a one time investment in a 10-year bonds versus five times into two-year bonds). 

Understanding term premium and steepness

The trend in the term premium largely coincides with the trend of the curve slope which is the difference between a 10-year bond and a 2-year bond, for example. However, it is different in nature. The term premium is a theoretical construct and the two most popular models used to extract this premium from a risk-free neutral rate are the Adrian, Crump and Moench (ACM) model and the Kim and Wright (KW) model. 

Mind the gap

The term premium embedded in the US 10-year yield rose by around 150bp during the third quarter of last year. Bond investors demanded a higher premium due to concerns around a widening in the US fiscal deficit and the country’s exuberant debt levels. 

The fiscal deficit reached $1.6 trillion in the year to April 2024¹, from $1.38 trillion the year before, adding to the $34 trillion of publicly held debt. At the end of this fiscal year, the Congressional Budget Office (CBO) anticipated that the debt will equate to 100% of US gross domestic product. In other words, higher than at any time since the second World War with the expectation for the ratio to increase to over 115% by 2034, according to the CBO. 

Higher tax revenues and a more resilient US economy mean the immediate fiscal deficit, as well as the Treasury supply, may not be as high as initially feared, but it is still worryingly high.  

As pointed out before, higher deficits do not necessarily translate into higher yields. This is because governments historically took on extraordinary debt during phases of crisis or recessions. And in these situations (like seen during the global financial crisis of 2007-2009, or the COVID-19 pandemic) fiscal accommodation is met with monetary accommodation. 

For instance, during the pandemic the US Federal Reserve (Fed) slashed policy rates by 225bp and absorbed almost three trillion dollars of US Treasury bills and bonds in its System 0pen Market Account (SOMA) portfolio (see chart). 

The Fed absorbed part of the higher bond supply from 2012

Comparison of the term premium with US 10-year Treasuries and the US Treasury surplus/deficit and the fed funds rate against the Fed’s SOMA account Treasury notes and bonds

Higher fiscal deficit and term premium 

Upward pressure as a result of higher leverage and bond supply could materialise as observed in 2013 (or the so-called ‘Taper tantrum’ when the Fed shocked financial markets by announcing a reduction of Treasury purchases), or in 2016 (as President Donald Trump unveiled debt-fuelled growth measures). 

In its recent report “Fiscal Policy in the Great Election Year” the International Monetary Fund (IMF) estimates that a one percentage point increase in the US primary deficit is associated with an 11 basis point rise in the respective term premium² (see chart). 

Periods when a rise in term premium led to higher long end yields

Taking a closer look at the relationship between the Adrian Crump and Moench US 10-year term premium estimate 

Term premium coming back

In the same report the IMF pointed to the US and China as the main drivers for global debt to reach 99% to GDP by 2029. Legacy fiscal measures from the pandemic crisis, population ageing, and climate change are some of the adverse factors cited. In addition, the risk of fiscal slippage appears to be larger during election years (elections are hardly won with austerity measures), according to the IMF. So higher term premium could be on the horizon.

But while higher term premium can lead to higher rates on the long end, this is usually only a temporary phenomenon. The more dominating dynamic behind a rise in term premium is the classical so called ‘bull curve’ steepening; at times when the Fed cut rates while the long end does not mirror the move (see chart). Interestingly, during such times, overall yield levels drop sharply.

Curve steepening causing higher term premium and lower long end rates

Comparison of US 10-year yields with the calculated term premium indicates the link between a falling term premium and spread between the 10-year and 2-year Treasuries

The verdict

The latest rise in yields was not caused by a rise in term premium but further fiscal slippage and bond supply concerns could likely lead to a renewed rise in term premium and higher rates on an absolute measure. However, such a dynamic in the bond market would probably be more temporary in nature. 

A higher term premium does not always translate into significantly higher rates that persist for an extended period. This is because ultimately it is the path of policy rates and cycles which are likely to remain the dominant driver for yields. Less discount does not necessarily mean higher yields over the long term. Higher volatility may provide an opportunity to take on duration.