The rise in the Canadian term premium in a global context

In Canada and abroad, yields on long-term government bonds have stayed high even as policy interest rates have fallen. This is due to rising term premiums―the extra compensation investors demand for holding these bonds. A key factor driving higher term premiums is global concerns about the ability of markets to absorb substantial amounts of government debt.

Yields on long-term government bonds play a crucial role in the economy by directly influencing the interest rates charged on mortgages and business loans.

Changes in these yields often follow changes in the policy interest rates set by central banks. But since September 2024, yields on long-term government bonds have remained elevated even as central banks reduced their policy interest rates (Chart 1).

Why haven’t yields tracked policy rates more closely?

Part of the reason lies in the term premium, which is how much additional compensation investors demand for buying long-term government bonds. Our research suggests that the term premium has recently risen across most advanced economies—including in Canada—to levels not seen in years.

The Canadian term premium reached its highest level in over a decade

Investors demand a premium for locking themselves into a long-term bond with a fixed interest rate. Essentially, the term premium compensates investors for the possibility of unexpected changes in short-term interest rates in the future. These unanticipated rate changes can arise when underlying risks materialize, such as inflation surprises, shifts in fiscal sustainability or strains in market liquidity.

The term premium can be an important driver of changes in yields. And it can move independently from changes in expectations for monetary policy—what the market believes the future path will be for the central bank’s policy interest rate. These expectations also influence long-term yields.

Unfortunately, neither component—monetary policy expectations nor the term premium—can be observed directly and therefore must be estimated. Although several methods can be used, the results can differ.

Given these issues, we use two model-based approaches:

• a Canadian version of the Adrian, Crump and Moench (ACM) model developed by the Federal Reserve Bank of New York
• the Shadow Rate model developed by Bank of Canada researchers

Both models rely on historical co-movements across yields on bonds of different maturities to estimate expected paths for policy interest rates. The difference between the expected path and actual long-term yields is defined as the term premium. However, the Shadow Rate model explicitly recognizes that in response to economic shocks:

• short-term yields move less when policy interest rates are near the zero lower bound
• longer-term yields continue to move, reflecting changes in expectations and the term premium

Chart 2 shows how much the term premium and rate expectations have affected yields on 10-year Government of Canada bonds.

Chart 2: The term premium in Canada has risen to levels not seen in over a decade

Estimated contributions to long-term bond yields

For each component, both models broadly align on the direction of changes over time. But they show occasional differences in the magnitude of change. They also agree on what has kept long-term yields on Government of Canada bonds relatively flat in recent years. While monetary policy expectations have declined with the Bank’s policy interest rate, the term premium has increased since 2023 and is now at levels not seen in over a decade.

Canada’s term premium moves closely with that of other advanced economies

Given the recent increase in Canada’s term premium, we wondered if similar dynamics were affecting long-term bond yields in other countries.

To explore this, we estimate the term premium for other advanced economies, using the same ACM model and a consistent sample period—from 1995 to March 2026.

Chart 3 shows that the Canadian term premium has moved generally in tandem with those of other advanced economies, highlighting that increases since 2023 are a global phenomenon. Correlations between the Canadian term premium and those in the United States and other advanced economies are both high, at around 0.92.

This finding makes sense since global forces heavily influence yields in a small open economy like Canada’s. Indeed, Canadian long-term government bond yields tend to closely track movements in US Treasury yields. Common shocks and similar monetary policy responses in Canada and the United States mean that Canadian and US bonds are exposed to many of the same risks. They also share comparably low default and liquidity risks. Together, these factors make them highly substitutable in investor portfolios, thus aligning their term premiums.

Growing fiscal indebtedness is raising concerns across global markets

Several factors may be contributing to the increase in term premiums across advanced economies. However, market intelligence gathered by the Bank during regular conversations with financial market participants suggests a key factor is a growing unease about the market’s ability to absorb the large volume of government debt being issued globally.

In recent years, government borrowing has increased markedly across many jurisdictions. Pandemic-era programs substantially raised public debt levels, which may rise further because of new spending pressures—most notably higher military and defence spending. As a result, governments across advanced economies are issuing large volumes of long-term bonds at a time when the supply of these bonds is already elevated.

At the same time, the investor base for government bonds has shifted in important ways.

During the pandemic, central banks absorbed a significant share of new issuance through asset purchase programs, which put downward pressure on yields. As these programs have been wound down, central banks have stepped back from purchasing government bonds and, in some cases, are actively reducing the size of their balance sheets by selling their purchased bonds on secondary markets.

Overall, this has left private investors to absorb a much larger share of government debt while the borrowing needs of governments have grown. These investors generally do not seem concerned about sovereign defaults and higher inflation based on the market prices for these risks—from credit-default or inflation swaps, for example. Instead, they appear to be seeking compensation for purchasing large amounts of government debt.

Tracking changes in the term premium helps inform monetary policy

Global financial markets are deeply integrated, meaning that forces in other countries can affect financial conditions in Canada. Policy-makers need to understand where these forces are coming from when making decisions about monetary policy. In this context, our work offers valuable perspectives by examining the different drivers of long-term interest rates in Canada.

The Bank will now publish measures of the term premium—using both the ACM and Shadow Rate models—on its financial stability indicators webpage and will update them every quarter.

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