One gilt
Inside the Yield
The yield may be thought of the return required to justify the risk of buying this part of the curve. But can we decompose that risk into constiuent parts?
Term premium
A ten-year gilt pays for two different things. One is the path of short rates being locked in. If the one-year yield were simply going to average some number for a decade, and nobody charged for risk, the ten-year yield would be that average. It is not. The difference is the term premium: the extra yield for fixing a rate for years instead of rolling one-year gilts.
It is not a forecast error, and it is not a credit rating. Inflation may come in higher than expected. Real rates may rise, and the bond's price fall. Or the long gilt may be the bond that dealers and pension funds have to sell at once. Those are different risks. They all sit in the gap between the yield and the expected path of short rates.
The ten-year gilt yield, in pieces
The term premium is one way of looking into the yield, and not everyone agrees that this is how it comes apart. It is not a number we get from the yield. It is an analysis. The expected path and the term premium on the chart above are estimated by a three-step regression1 for a Gaussian model of the yield curve.2 Opening that analysis into five pieces is a further choice made for this site. The bar is the ten-year spot yield, in the same order as the stack on the curve page. Expected inflation and the inflation risk premium share a page, and the expected real rate and the real-rate term premium share another.
Expected inflation includes the inflation risk premium. Expected real rate includes the real-rate term premium. Then Gilt over swap. How CPI and RPI are built is on CPI/RPI. The same five slices, along the curve rather than at ten years, are at the bottom of The Curve.