Will the True Treasury Term Premium Please Stand Up?

There’s a gauge in the bond market that’s important to understand yet difficult to calculate and impossible to observe. It can help investors figure out how much they are getting paid for the risk of holding bonds over a longer time period. It can also inform officials as they set a course for monetary policy.

At its May 2023 Secular Forum, PIMCO concluded that “with rising government debt, we expect the yield curve to steepen as investors demand more compensation from bonds” over the coming years (for more, see our Secular Outlook, “The Aftershock Economy”). We will be revisiting this topic along with many others at our 2024 Secular Forum this week.

This compensation – the term premium – is the expected excess return that investors earn by holding longer-dated U.S. Treasuries versus rolling over T-bills. (Term premium can apply to any sovereign bond issue, but this note will focus on the U.S.) Historically, the term premium has been positive. The intuition is that because the volatility of returns over any given holding period on a long-duration bond is much greater than the volatility of returns on a T-bill investment over the same holding period, investors expect to earn compensation for taking on that risk.

A higher term premium bodes well for investors in the long run. In the near term, it helps investors determine which bond maturities offer the best value while minimizing both interest rate (duration) risk and reinvestment risk. As discussed in a recent essay by my colleagues Marc Seidner and Pramol Dhawan, factors other than the stock of Treasuries outstanding can also influence the equilibrium term premium (for more, see our PIMCO Perspectives, “Term Premium Poised to Rise Again, With Widespread Asset Price Implications”).

The Treasury term premium is important not only to bond investors, but also to the Federal Reserve. Last fall, when Treasury yields rose sharply, concerns about the U.S. fiscal trajectory and political dysfunction were seen as an important driver. The Fed itself said an increase in the term premium contributed to the sell-off,1 and cited in its 1 November 2023 policy statement the resulting tightening in financial conditions as one reason to keep rates on hold at that meeting.

While understanding the term premium is important, the term premium itself is unobservable. In this essay we discuss how estimates of the term premium are constructed, how to interpret them, and how they are tied to expectations about monetary policy. Although these methodologies differ when it comes to details, they all appear to indicate a recent rise in investor compensation. Looking ahead, a key question is whether it will rise more.