Term Risk Premiums

Observed yields for bonds at different terms/maturities are the implicit combination of two driving market factors:

• an expectation of increases or decrease in short term rates in the future -- knowledge of future rate change expectations help price forward starting instruments and provide a market expectation of rates;
• a term risk compensation factor, a reward for borrowers foregoing funds for longer periods of time -- knowledge of the term risk premium helps price other term compensation factors and provides and indication of the overall risk appetite of the market.

For many years the term risk premium has been negligible, in some markets even negative, implying a market appetite for longer term instruments which provide a stability and assurance of returns. Since the increase in government budget deficits after COVID pandemic financial support and the more recent persistent inflation term risk compensation has increased.

ACM Model

It is difficult to decouple these two factors and provide precise quantitative estimates of the term risk premium. A common method is the Adrian Crump and Moench (ACM) model. This model extracts a range of pricing factors of the yield curve

In the first step, the ACM model decomposes returns () into into predictable components () and factor innovations () by regressing principal components/factors on their lagged levels using a Vector Autoregression (VAR) model.

In the second step, log excess returns (), over the risk free rate () which is the instanteous short rate, are regressed on lagged factors () and contemporaneous pricing factor innovations (). The log excess return over interval t:

In the third step, market price of risk parameters are obtained from a cross-sectional regression of the exposures of returns to the lagged pricing factors onto exposures to contemporaneous pricing factor innovations.

With these parameters a recursive calculation bond pricing solution estimates the risky and risk free yield, with the difference implying the term risk premium.

Major Currency Term Risk Premiums

Australian (AUD), United States (USD) and European (Euro) term risk premiums are highly correlated reflecting common expectations of global inflation and risk compensation. Between 2024 and the start of 2026, after all central banks increased rates in response to the post COVID inflation spike, nominal bond yields have continued to rise. Across all three currencies this rise was driven by the term risk premium. Since the start of 2026 and the war in Iran, the expectation of falling interest rates has reversed.

Term Premium Term Structure

The term premium estimation all provide an insight to the extent to which compensation increases with time and the market implied forward rate path. The term premium generally increases with term. Periods of inversion can occur, they result from negative interest rates or when markets are supported by quantitative easing at the short end.

Forward Rates

In setting forward rates the market generally prices a reversion of interest rates over time to the expected long run rate. Long run rates are not necessarily constant, they move based on the expectations of long run policy settings, for example the level of rates required to keep inflation within the policy band.