Quantifying the Determinants of the US Treasury Term Premium: Theory and Empirical Results

When considering the trade-off between equities and government securities in active or passive investment management, important inputs are the expected rates of return on equity and Treasury bonds of differing maturities, the volatilities of those assets, and the correlation of their returns. This article develops a portfolio-theoretic framework for understanding the determinants of the US Treasury term premium, which is defined as the excess rate of return on the US Treasury portfolio relative to the expected average of the three-month T-Bill short-term risk-free rate of interest over the term of the analysis. In the theoretical component, we derive the term premium within an asset pricing framework in which investors allocate wealth between the equity market and the Treasury market, highlighting the role of bond volatility, equity-bond covariance, and portfolio allocation in determining equilibrium term premiums. In the empirical analysis, we examine how both bond volatility and the diversification benefit of holding Treasury bonds, as measured by the equity-bond correlation structure, affect the term premium across alternative market environments. Our results suggest that the Treasury term premium is closely linked not only to interest-rate risk but also to the changing diversification properties of Treasury securities within multi-asset portfolios. Beyond its implications for investment management, a better understanding of the drivers of the term premium has important implications for fixed-income portfolio construction, risk management, and macro-financial policy analysis.