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.

RELATED TERMS
  1. Expectations Theory

    The hypothesis that long-term interest rates contain a prediction ...
  2. Market Segmentation Theory

    A modern theory pertaining to interest rates stipulating that ...
  3. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
  4. Term To Maturity

    The remaining life of a financial instrument. In bonds, it is ...
  5. Yield Pickup

    The additional interest rate an investor receives when selling ...
  6. Term Bond

    Bonds from the same issue that share the same maturity dates. ...
Related Articles
  1. Markets

    Interest Rate Predictions With Expectations Theory

    The expectations theory uses long-term interest rates to predict future short-term interest rates.
  2. Managing Wealth

    How To Evaluate Bond Performance

    Learn about how investors should evaluate bond performance. See how the maturity of a bond can impact its exposure to interest rate risk.
  3. Markets

    How Do I Calculate Yield To Maturity Of A Zero Coupon Bond?

    Yield to maturity is a basic investing concept used by investors to compare bonds of different coupons and times until maturity.
  4. Managing Wealth

    Find The Right Bond At The Right Time

    Find out which bonds you should be investing in and when you should be buying them.
  5. ETFs & Mutual Funds

    Key Strategies To Avoid Negative Bond Returns

    It is difficult to make money in bonds in a rising rate environment, but there are ways to avoid losses.
  6. Managing Wealth

    5 Basic Things To Know About Bonds

    Learn these basic terms to breakdown this seemingly complex investment area.
  7. Markets

    Bond Basics: Yield, Price And Other Confusion

    Investopedia Explains: Bond yield, Bond price, yield to maturity, the link between price and yield and bond price in the market.
  8. Markets

    Corporate Bond Basics: Learn to Invest

    Understand the basics of corporate bonds to increase your chances of positive returns.
  9. Markets

    5 Fixed Income Plays After the Fed Rate Increase

    Learn about various ways that you can adjust a fixed income investment portfolio to mitigate the potential negative effect of rising interest rates.
  10. Trading

    Top 6 Uses For Bonds

    We break down the stodgy stereotype to see what these investments can do for you.
RELATED FAQS
  1. What does market segmentation theory assume about interest rates?

    Learn about how the market segmentation theory for different maturities of interest rates seeks to describe the shape of ... Read Answer >>
  2. What does it signify if the term structure of an interest rate's curve is positive?

    Understand what the term structure of interest rates is used to measure. Learn what a positive term structure signifies to ... Read Answer >>
  3. What happens to the price of a premium bond as it approaches maturity?

    Learn how bonds trade in regard to premiums and discounts, and how bond prices shift closer to par value as bonds approach ... Read Answer >>
  4. What is the difference between yield to maturity and the yield to call?

    Determining various the various yields that callable bonds can provide investors is an important factor in the bond purchasing ... Read Answer >>
  5. Why is my bond worth less than face value?

    Find out how bonds can be issued or traded for less than their listed face values, and learn what causes bond prices to fluctuate ... Read Answer >>
  6. Do long-term bonds have a greater interest rate risk than short-term bonds?

    The answer to this question lies in the fixed income nature of bonds and debentures, often referred to together simply as ... Read Answer >>
Hot Definitions
  1. Duration

    A measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. ...
  2. Dove

    An economic policy advisor who promotes monetary policies that involve the maintenance of low interest rates, believing that ...
  3. Cyclical Stock

    An equity security whose price is affected by ups and downs in the overall economy. Cyclical stocks typically relate to companies ...
  4. Front Running

    The unethical practice of a broker trading an equity based on information from the analyst department before his or her clients ...
  5. After-Hours Trading - AHT

    Trading after regular trading hours on the major exchanges. The increasing popularity of electronic communication networks ...
  6. Omnibus Account

    An account between two futures merchants (brokers). It involves the transaction of individual accounts which are combined ...
Trading Center