What is the Preferred Habitat Theory

The preferred habitat theory is 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

Securities in the debt market can be categorized into three segments – short-term, intermediate-term, and long-term debt. When these term maturities are plotted against their matching yields, a yield curve is shown. The movement in the shape of the yield curve is influenced by a number of factors including investor demand and supply of the debt securities. The market segmentation theory states that the yield curve is determined by supply and demand for debt instruments of different maturities. The level of demand and supply is influenced by the current interest rates and expected future interest rates. The movement in supply and demand for bonds of various maturities causes a change in bond prices. Since bond prices affect yields, an upward (or downward) movement in the prices of bonds will lead to a downward (or upward) movement in the yield of the bonds.

If current interest rates are high, investors expect interest rates to drop in the future. For this reason, the demand for long-term bonds will increase since investors will want to lock in the current prevalent higher rates on their investments. Since bond issuers attempt to borrow funds from investors at the lowest cost of borrowing possible, they will reduce the supply of these high interest-bearing bonds. The increased demand and decreased supply will push up the price for long-term bonds, leading to a decrease in long-term yield. Long-term interest rates will, therefore, be lower than short-term interest rates. The opposite of this phenomenon is theorized when current rates are low and investors expect that rates will increase in the long-term.

The preferred habitat theory is a variant of the market segmentation theory which suggests that expected long-term yields are an estimate of the current short-term yields. The reasoning behind the market segmentation 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 investors 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. Bond investors prefer a certain segment of the market in their transactions based on term structure or the yield curve and will typically not opt for a long term debt instrument over a short term bond with the same interest rate. The only way a bond investor will invest in a debt security outside his or her maturity term preference, according to the preferred habitats theory, is if s/he is adequately compensated for the investment decision.

The risk premium must be large enough to reflect the extent of aversion to either price or reinvestment risk.

For instance, bondholders who prefer to hold short-term securities due to the interest rate risk and inflation impact on longer term bonds will purchase long-term bonds if the yield advantage on the investment is significant.