How does the preferred habitat theory define the shape of an normal yield curve

CFA Level II
#1

Hello,

I am confused on how the preferred habitat theory would help define shape of a “normal” (upward sloping) yield curve.

I understand what the theory means but it does not make sense to me in the context of an upward sloping/normal sloping yield curve.

Thanks,

#2

Imagine that there are 20 investors:

  • Eight of them want 2-year bonds
  • Six of them want 5-year bonds
  • Four of them want 10-year bonds
  • Two of them want 20-year bonds

Imagine that there are 20 bonds available:

  • Four 2-year bonds
  • Four 5-year bonds
  • Four 10-year bonds
  • Four 20-year bonds
  • Four 30-year bonds

According to preferred habitat theory, the yield on the 30-year bonds will have to exceed that of 20-year bonds so that you can entice not only the two investors who want 20-year bonds to accept 30-year bonds, but two of the investors who want 10-year bonds. Similarly, the 20-year yield will have to exceed that of the 10-year so that you can entice the other two investors who want 10-year bonds, plus two of the investors who want 5-year bonds.

And so on.

You end up with a normal yield curve.

#3

If you want investors to hold 20 year bonds, why would you have to entice investors holding 5 year bonds (not just investors for 10 year bonds) to move away from their preferred habitat and buy 20 year bonds? Is there a specific for enticing investors holding bonds and specific maturities to move to holding 20 year bonds.

There are only 4 bonds avaliable at the 20 year maturity and bringing in two investors from the 10 and 5 year bonds would have a total of 6 investors vying for 4 20 year bonds.

#4

But there are also 30-year bonds that are trying to entice investors away from the 20-year bonds.

#5

Is the goal to allocate an even number of investors across all the maturities? Does the preferred habitat theory use the concept of “equilibrium” when allocating investors across different maturities?

#6

I simply gave an example to answer your question: if investors want shorter maturities and issuers want to issue longer maturities, you can get a normal yield curve under preferred habitat theory.