Preferred Habitat Theory

AAA

DEFINITION of '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.

INVESTOPEDIA EXPLAINS '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. Bond

    A debt investment in which an investor loans money to an entity ...
  2. Term Structure Of Interest Rates

    The relationship between interest rates or bond yields and different ...
  3. Liquidity Preference Theory

    The idea that investors demand a premium for securities with ...
  4. Interest Rate

    The amount charged, expressed as a percentage of principal, by ...
  5. Expectations Theory

    The hypothesis that long-term interest rates contain a prediction ...
  6. Biased Expectations Theory

    A theory that the future value of interest rates is equal to ...
RELATED FAQS
  1. What does market segmentation theory assume about interest rates?

    Market segmentation theory states there is no relationship between the markets for bonds of different maturity lengths. MST ... Read Full Answer >>
  2. Where can I buy government bonds?

    The type of bond determines where you can purchase it, so you need to decide which type of bond you would like to purchase ... Read Full Answer >>
  3. What are the advantages and disadvantages of buying stocks instead of bonds?

    This is a common question among investors. Stocks and bonds differ dramatically in their structures, payouts, returns and ... Read Full Answer >>
  4. What is the difference between compounding interest and simple interest?

    Interest is the cost of borrowing money, where the borrower pays a fee to the owner for using the owner's money. The interest ... Read Full Answer >>
  5. What is the relationship between modified duration and interest rates?

    Modified duration is a formula that measures the value of a bond in relation to changes in interest rates. Modified duration ... Read Full Answer >>
  6. How does inflation affect a company's short-term investments?

    Inflation marginally erodes a company's short-term investments. Short-term investments are typically ultra-safe liquid assets, ... Read Full Answer >>
Related Articles
  1. Investing

    The Advantages Of Bonds

    Bonds contribute an element of stability to almost any portfolio and offer a safe and conservative investment.
  2. Bonds & Fixed Income

    Corporate Bonds: An Introduction To Credit Risk

    Corporate bonds offer higher yields, but it's important to evaluate the extra risk involved before you buy.
  3. Bonds & Fixed Income

    Green Bonds: Fixed Returns To Fix The Planet

    Fixed-income investors are no longer left out of the green investing revolution.
  4. Bonds & Fixed Income

    How Bond Market Pricing Works

    Learn the basic rules that govern how bond prices are determined.
  5. Mutual Funds & ETFs

    Bond ETFs: A Viable Alternative

    Discover the advantages of a security that tracks bond index funds, but trades like a stock.
  6. Bonds & Fixed Income

    Why Bad Bonds Get Good Ratings

    Credit ratings are not the only tool to rely on when assessing bonds. Find out why they sometimes fall short.
  7. Bonds & Fixed Income

    Convertible Bonds: Pros And Cons For Companies And Investors

    Find out why businesses choose this type of financing and what effect this has on investors.
  8. Home & Auto

    The Bear On Bonds

    Bond investing is a stable and low-risk way to diversify a portfolio. However, knowing which types of bonds are right for you is not always easy.
  9. Investing Basics

    Treasury Inflation-Protected Securities (TIPS)

    Treasury inflation-protected securities are treasury securities that make adjustments for inflation as reflected in the Consumer Price Index.
  10. Investing Basics

    What is the Coupon?

    In the financial world, “coupon” represents the interest rate on a bond.

You May Also Like

Hot Definitions
  1. Expected Return

    The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, ...
  2. Carrying Value

    An accounting measure of value, where the value of an asset or a company is based on the figures in the company's balance ...
  3. Capital Account

    A national account that shows the net change in asset ownership for a nation. The capital account is the net result of public ...
  4. Brand Equity

    The value premium that a company realizes from a product with a recognizable name as compared to its generic equivalent. ...
  5. Adverse Selection

    1. The tendency of those in dangerous jobs or high risk lifestyles to get life insurance. 2. A situation where sellers have ...
Trading Center