- 10/3/2025

Video: rising term premium

2 min

Which factors influence the term premium?

So, what exactly is a risk or term premium? The nominal interest rate is the total of the real interest rate plus a projected rate of inflation. The real interest rate, meanwhile, is the sum of the current and all expected future short-term rates – the monetary path – and a risk premium. This premium is a form of compensation for investors for the risk they undertake by holding a long-term bond as opposed to a series of short-term bonds.

The term premium reflects risks that may arise. What is the likelihood that structural growth, or inflation expectations, or the supply of or demand for bonds will change during this period? Recent geopolitical developments may negatively affect trade flows. Less trade leads to higher inflation risk and a higher risk premium. As a result, central banks also have to reinvest less foreign exchange reserves. Demand for U.S. government bonds is already under pressure among geopolitical competitors following the freezing of dollar reserves held by Russia.

The more future shocks, the more uncertain the interest rate path and the higher the risk premium. In today’s global economy, these shocks are increasing systematically. In the short term, there is the Trump shock. In the slightly longer term, other shocks will gradually come to the surface. The green transition, with its massive investment needs, raw material shortages, and regular climate and weather disasters will result in inflationary shocks. Larger budget deficits boost potential growth, absorb excess savings through a greater supply of safe assets, and increase inflation expectations. All three drive the risk premium higher. According to the Bank for International Settlements, the increasing share of older people relative to the declining working-age population will push up inflation in industrialised countries by an average of 3 percentage points over the period 2010-2050.

The end of 40 years of declining interest rates and the beginning of a new era

Between 1982 and 1995, the term premium fell from 4.6% to 1%. From 1996 until 2014, it fluctuated between 1% and -1%. Since then, it has been almost continually negative, plummeting to an absolute low of almost -2% in 2020. Low inflation put additional pressure on the nominal interest rate.

Since 2020, the risk premium has risen from almost -2% to 0.5%. More shocks can push the risk premium towards its long-term average of 2 to 3 per cent in the long term. The nominal interest rate will then be higher than interest rates during the past two decades. The 5% peak of 2007 will make way for a new all-time high during the current or next upswing of the business cycle.

Companies hoping to refinance their loans at the historically low interest rates of 2010-2021 are thus waiting in vain. The steady rise of the risk premium due to increasing uncertainty and shocks has ushered in a new era for interest rate markets.