Closely related to the liquidity premium theory is the preferred habitat theory, which takes a somewhat less direct approach to modifying the expectations hypothesis but comes to a similar conclusion. It assumes that investors have a preference for bonds of one maturity over another, a particular bond maturity (preferred habitat) in which they prefer to invest. Because they prefer bonds of one maturity over another, they will be willing to buy bonds that do not have the preferred maturity (habitat) only if they earn a somewhat higher expected return. Because investors are likely to prefer the habitat of short-term bonds over that of longer-term bonds, they are willing to hold long term bonds only if they have higher expected returns. This reasoning leads to the same Equation 3 implied by the liquidity premium theory with a term premium that typically rises with maturity.
The relationship between the expectations theory and the liquidity premium and preferred habitat theories is shown in Figure 5. There we see that because the liquidity premium is always positive and typically grows as the term to maturity increases, the yield curve implied by the liquidity premium theory is always above the yield curve implied by the expectations theory and generally has a steeper slope. (Note that for simplicity we are assuming that the expectations theory yield curve is flat.)