A New ‘Preferred Habitat’ Yield Curve Parameter

Abstract

Since the GFC, the supply of US government bonds has grown significantly, involving large changes in the structure of Treasury debt. This has important implications because many investment funds target duration to immunize their liabilities, incentivised by shortfall risks and new legislation. This paper tries to incorporate these quantity and duration effects into existing term structure models using a new 4-factor decomposition comprising level, slope, curvature and position of the hump (D*) in the yield curve along the maturity/duration axis. D* is measured using US data to create a monthly time-series 1946-2015. This averages 6¼ years, with a 10-month standard deviation. In the absence of more granular data, this series may relate to the preferred habitat of investors and serve as another measure of their risk appetite, where low D* equates to high risk aversion. D* is a statistically significant predictor of economic activity and corporate credit spreads around one-year ahead and it allows a different interpretation of the 2007/08 Financial Crisis and Great Recession.