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In theory, investors are compensated for the opportunity cost of locking capital up over an extended period of time and forgoing the possibility of using it for shorter-term investments. For example, an investor could buy a 10-year bond at say 4% and wait patiently until the 10 years are up. Alternatively, this investor could invest the funds for one year at say 3% and subsequently reinvest the same funds for a further nine years. If interest rates have risen sharply during the first year, the investor can reinvest at a much higher rate. For example, if this nine-year investment is made at 5%, the total 10-year return will be 4.8%, instead of 4% for the 10-year bond. For this reason, the term structure of interest rates, in addition to reflecting interest-rate expectations, includes what is called a ‘term premium’, i.e. the premium that remunerates the investor for the risk of not knowing the future path of interest rates.
The graph above plots the history of ex ante term premium estimates and ex post observations for 10-year US Treasury bonds since 1962. The ex post curve is calculated by comparing the 10-year Treasury bond yield with the internal rate of return on a strategy that annually reinvests for a period of one year each time. Since the 1980s, the long-term investment strategy has delivered on average 2.7% more than the annual reinvestment strategy. However, during the 1960s and 70s, the rising-rate environment led to the annual reinvestment strategy providing higher returns.
Broadly speaking, the ex ante term premium estimate uses the Federal Reserve Bank of New York’s model, which seeks to strip out short-term rate expectations. Estimates are currently indicating a negative term premium due to central bank policies along with regulatory constraints on investors to purchase duration and therefore bonds with long maturities. But for investors not subject to such constraints, and aside from any tactical decision-making, the wisdom of investing in long-dated bonds may be queried.
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The opinion expressed above is dated 5 December 2019, and liable to change.
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