What is the Preferred Habitat Theory?

The preferred habitat theory, a term structure, which is a variant of the liquidity premium theory; states that in addition to interest rate expectations, investors have distinct investment horizons and require a meaningful premium to buy bonds with maturities outside their "preferred" maturity, or habitat. Proponents of this theory believe that; ceteris paribus, there is a preference for holding short-term bonds as compared to long-term bonds by investors and that the yields realized on longer-term bonds should be higher than those realized on shorter-term bonds. This theory implies that bond market investors show a preference for investment timeframes, and such preference dictates the slope of the term structure.

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How Does the Preferred Habitat Theory Work?

A yield curve's shape is derived by plotting the three categories of securities in the debt market (short-term, intermediate-term and long-term) against their matching yields whose is influenced by a number of factors including investor demand and supply of the debt securities. The market segmentation theory, whose variant is the preferred habitat theory states that the yield curve is determined by supply and demand for debt instruments of different maturities. This theory reasoned that bond investors only care about yield and are willing to purchase bonds of any maturity. The preferred habitat theory also implies that investors will only invest in debt security outside his maturity term preference if he is well compensated for the investment decision.