Preferred Habitat Theory

What Is the Preferred Habitat Theory?

The preferred habitat theory is a term structure hypothesis recommending that different bond investors favor a specific maturity length over another, and they are simply able to buy bonds outside of their maturity preference assuming risk premia for other maturity ranges are accessible.

This theory likewise proposes that, if all else is equivalent, investors like to hold shorter-term bonds in place of longer-term bonds and that is the justification for why yields on longer-term bonds ought to be higher than shorter-term bonds.

Grasping the Preferred Habitat Theory

Securities in the debt market can be ordered into three segments — short-term, intermediate-term, and long-term debt. At the point when these term maturities are plotted against their matching yields, the yield curve is shown. The movement looking like the yield curve is impacted by a number of factors including investor demand and supply of the debt securities.

Interestingly, market segmentation theory states that the yield curve is determined by supply and demand for debt instruments of various maturities. The level of demand and supply is affected by the current interest rates and expected future interest rates. The movement in supply and demand for bonds of different maturities causes a change in bond prices. Since bond prices influence yields, a vertical (or descending) movement in the prices of bonds will lead to a descending (or up) movement in the yield of the bonds.

Assuming that current interest rates are high, investors expect interest rates to drop from now on. Thus, the demand for long-term bonds will increase since investors will need to lock in the current common higher rates on their investments. Since bond issuers endeavor to borrow funds from investors at the lowest cost of borrowing potential, they will reduce the supply of these high-interest-bearing bonds.

The increased demand and diminished supply will push up the price for long-term bonds, leading to a reduction in long-term yield. Long-term interest rates will, in this manner, be lower than short-term interest rates. Something contrary to this phenomenon is hypothesized when current rates are low and investors expect that rates will increase in the long term.

Preferred habitat theory says that investors care about the return as well as maturity. In this manner, to tempt investors to buy maturities outside their preference, prices must incorporate a risk premium/markdown.

Preferred Habitat Theory versus Market Segmentation Theory

The preferred habitat theory is a variation of the market segmentation theory which proposes that expected long-term yields are an estimate of the current short-term yields. The thinking behind the market segmentation theory is that bond investors just care about yield and will buy bonds of any maturity, which in theory would mean a flat term structure except if expectations are for rising rates.

The preferred habitat theory develops the expectation theory by saying that bond investors care about both maturity and return. It recommends that short-term yields will quite often be lower than long-term yields due to an additional premium expected to tempt bond investors to purchase longer-term bonds as well as bonds outside of their maturity preference.

Bond investors favor a certain segment of the market in their transactions in light of term structure or the yield curve and will normally not opt for a long-term debt instrument over a short-term bond with a similar interest rate. The main way a bond investor will invest in a debt security outside their maturity term preference, as per the preferred habitat theory, is on the off chance that they are sufficiently compensated for the investment decision. The risk premium must be sufficiently large to mirror the degree of aversion to one or the other price or reinvestment risk.

For example, bondholders who like to hold short-term securities due to the interest rate risk and inflation impact on longer-term bonds will purchase long-term bonds in the event that the yield advantage on the investment is critical.

Highlights

• The preferred habitat theory says that investors incline toward shorter maturity bonds over longer-term ones.
• Investors are possibly ready to buy outside of their preferences if a sufficient risk premium (higher yield) is connected to those bonds.
• A ramifications of this theory can assist with making sense of why yields on long-term bonds are normally higher.
• Meanwhile, market segmentation theory proposes that investors just care about yield, ready to buy bonds of any maturity.