Preferred Habitat Theory
Categories: Financial Theory
"Ahh! The bond investors in their natural habitat. See the three different species of bond investors by the water cooler, each with their own completely unique behaviors and preferences. While they might look the same on the outside, their bond investments reveal their true nature." -David Attenborough
The preferred habitat theory is that bond investors are creatures of habit. They generally stick to one maturity length of bonds. For instance, short-term bond investors will only check out the short-term bond market and yields if they’re bond shopping. Same goes for medium-term and long-term bond investors: they stay in their preferred bond-type market. Bond investors will only deviate from their typical bond-type if there’s a really good deal in the other bond-type markets.
Jerry, a medium-term bond guy, fits the preferred habitat theory. He only really has and looks to buy medium-term bonds. But at the watering hole...err, water cooler, Jerry learns about the great deal on long-term bonds happening right now. Jerry takes a look, and considers it carefully. Higher yields are great, but then he’ll have to hold that bond for longer than he’s used to. Decisions, decisions.
The preferred habitat theory assumes that yields on long-term bonds are higher than the yields on short-term bonds, which isn’t always the case...like right before a recession.
