Preferred Habitat Theory

What is the 'Preferred Habitat Theory'

A term structure theory suggesting that different bond investors prefer one maturity length over another and are only willing to buy bonds outside of their maturity preference if a risk premium for the maturity range is available. The theory also suggests that when all else is equal investors prefer to hold short-term bonds in place of long-term bonds and that the yields on longer term bonds should be higher than shorter term bonds.

BREAKING DOWN 'Preferred Habitat Theory'

The preferred habitat theory is an expansion on the expectations theory which suggests that long-term yields are an estimate of the future expected short-term yields. The reasoning behind the expectations theory is that bond investors only care about yield and are willing to buy bonds of any maturity, which in theory would mean a flat term structure unless expectations are for rising rates. The preferred habitat theory expands on the expectation theory by saying that bond investor's care about both maturity and return. It suggests that short-term yields will almost always be lower than long-term yields due to an added premium needed to entice bond investors to purchase not only longer term bonds, but bonds outside of their maturity preference.