Term Premium

Lend someone money for three months and you have a fair idea of what the world will look like when it comes back. Lend it for ten years and you do not. Inflation may change, interest rates may change, the borrower's circumstances may change, and you are locked in through all of it.

The term premium is what investors charge for that extra stretch of the unknown. The workbook puts it in one sentence in its discussion of fixed income securities: since the investment horizon in the capital market is longer, the uncertainty about future cash flows goes up, and investors require extra compensation for it.

The word to notice is term — the length of time. It is not a premium for the borrower being weak. A government can borrow for ten years and still pay a term premium, because the uncertainty being priced is about time, not about whether the government will pay.

Chapter 2 draws the line between the two markets by maturity:

• Money market securities have maturities of one year or less.
• The capital market is the place for long-term fund mobilisation.

The term premium lives in the gap between them. Hold the issuer constant — say, compare a government treasury bill with a long-dated government security — and credit risk is taken out of the comparison. What is left in the yield difference is largely the compensation for horizon.

It sits naturally beside the required-return build-up in Chapter 1. There the investor starts with the real risk-free rate, adds expected inflation to reach the nominal risk-free rate, and then adds a risk premium for uncertainty in the amount and timing of cash flows. A longer horizon widens that uncertainty, so a long-dated instrument carries a larger premium than a short-dated one from the same borrower. The term premium is simply that horizon component, named on its own.

The workbook gives no figure for its size, and it would be wrong to memorise one: it changes with the rate cycle and with how uncertain investors feel about the future.

The yields below are illustrative, chosen to show the arithmetic — the workbook does not quote market levels.

A family office has Rs 10 crore to park in government paper and is choosing between two instruments issued by the same borrower, the Government of India:

The issuer is the same, so there is no difference in credit risk. The 0.70 percentage point gap — 70 basis points — is the market's price for the longer horizon.

In rupees, the first year's income:

Treasury bill:  Rs 10 crore × 6.50% = Rs 65 lakh
G-sec:          Rs 10 crore × 7.20% = Rs 72 lakh
Term premium earned                  = Rs 7 lakh

That Rs 7 lakh is not free money. It is payment for accepting that over ten years rates, inflation and the value of the security can move a long way — and the office needs to be able to live with that before it takes the extra yield.

Chapter 2, section 2.2.2 (Fixed income securities), defines the term inside the classification of debt by maturity. Expect a direct question — "the extra compensation investors require for the longer horizon of the capital market is called…" — with risk premium, credit spread and liquidity premium as distractors. It also connects to Chapter 1's required rate of return and to interest rate risk, which is the loss a long-dated holder actually suffers when rates move.

• Term premium is about time, not credit quality. A government security can carry a term premium and no credit risk at all.
• Money market means one year or less. Questions sometimes offer "less than 91 days" or "up to three years" as the boundary. The workbook says one year.
• It is not the same as the risk premium in Chapter 1. The risk premium is the whole compensation for uncertainty in amount and timing; the term premium is the part attributable to a longer horizon.
• A higher yield on a long bond is not a sign that the issuer is weaker. Compare the same issuer across maturities before reading anything into it.
• Do not memorise a size. The workbook gives none, and it moves with the rate cycle.