Term Funding Premium—Time Is Money After All

Term premium plays an important role in understanding the evolution of interest rates, and has even been the target of monetary policy when short-term rates were at or near an effective lower bound. It is commonly defined as the difference between a long-term interest rate and the geometric average of short-term rates over the same horizon, making it unobservable. While many approaches exist to estimate term premium, they treat term premium as the market’s price for bearing interest rate risk. Although such frameworks have sufficed historically, they cannot explain the premium embedded in Treasury Floating Rate Notes (which carry no interest rate risk), or the premium implicit in swap spreads. In this paper, we present evidence from financial markets arguing for the explicit recognition of a different kind of premium that is associated with terming out funding without bearing interest rate risk—we call this term funding premium. We argue that in a market where the extension of term funding and the bearing of term interest rate risk are separable, it is useful to think of traditional notions of term premium as being comprised of term funding premium and term rate premium. We describe a model-independent approach to estimating term funding premium, define term rate premium as the difference between term premium (from three commonly used estimation models) and term funding premium, and examine their empirical characteristics. Finally, we identify a few possible applications to policy. Term funding premium has the potential to serve as a real-time signal of Treasury market stress. It may also have a role to play defining “convenience yields” and in guiding optimal Treasury issuance decisions.