Preferred Habitat Theory

What Is the Preferred Habitat Theory?

The preferred habitat theory is a term structure hypothesis suggesting that different bond investors prefer a particular maturity length over another, and they are only willing to buy bonds outside of their maturity preference if risk premia for other maturity ranges are available.

This theory also suggests that, if all else is equal, investors prefer to hold shorter-term bonds in place of longer-term bonds and that is the reason why yields on longer-term bonds should be higher than shorter-term bonds.

Understanding the 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, the 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. 

In contrast, 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.

Preferred habitat theory says that investors not only care about the return but also maturity. Thus, to entice investors to buy maturities outside their preference, prices must include a risk premium/discount. 

Preferred Habitat Theory vs. Market Segmentation Theory

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. 

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 their maturity term preference, according to the preferred habitat theory, is if they are 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.