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