What is the term premium?

The term premium is the additional compensation investors require for holding a long-term bond rather than repeatedly rolling over short-term securities. It represents the portion of long-term bond yields that cannot be explained by expectations for future short-term rates. A 10-year Treasury yield can be decomposed into (1) the average expected short-term rate over 10 years plus (2) the term premium.

The most widely cited measure is the Adrian-Crump-Moench (ACM) 10-year term premium, published by the Federal Reserve Bank of New York. Other models exist (Kim-Wright, Christensen-Rudebusch), and they can give different estimates. The ACM model uses Treasury yield curve data and a statistical framework to extract the term premium, acknowledging that it is not directly observable.

The term premium is driven by several factors. Inflation uncertainty is a primary driver: when investors are unsure about future inflation, they demand more compensation for holding nominal bonds whose real returns could be eroded. Fiscal policy also matters: larger government deficits increase Treasury supply, requiring higher yields (and a higher term premium) to attract buyers. Central bank balance sheet policies (QE/QT) directly affect the term premium by changing the amount of duration risk the private sector must absorb.

After being compressed and even negative for much of the 2010s (partly due to massive central bank QE), the term premium has risen since 2022, driven by inflation uncertainty, rising fiscal deficits, and quantitative tightening. A rising term premium pushes long-term yields higher independently of rate expectations, tightening financial conditions for mortgages, corporate investment, and asset valuations.

For equity investors, the term premium matters because it affects the discount rate applied to future earnings. A higher term premium, all else equal, reduces the present value of future cash flows and weighs on stock valuations, particularly for growth stocks with distant earnings. Understanding whether a rise in the 10-year yield is driven by rate expectations or the term premium has different implications for markets: a rate-expectations-driven rise signals a stronger economy, while a term-premium-driven rise is a pure tightening of financial conditions.