Preferred-habitat hypothesis:

The preferred-habitat hypothesis combines the expectations hypothesis and the segmented-markets hypothesis. The central idea of the preferred habitat theory is that while investors have a preference for loanable funds of specific terms to maturity as suggested by the segmented markets hypothesis, investors are willing to substitute away from their preferred terms if they are compensated for doing so. This compensation that must be offered to investors to make them purchase a different term to maturity than their preferred terms is called the term premium. For this reason, the preferred habitat theory is sometimes called the  liquidity premium theory. The rationale for the preferred habitat hypothesis is a combination of the rationale for the expectations hypothesis and the segmented-market hypothesis.

This hypothesis asserts that an investor will choose bonds on the basis of both the expected return of the bond and the  investor's preference for bonds with a particular maturity. An investor will purchase a bond with maturity different from his desired one only if he receives a term premium. This term period is merely the additional yield that must be promised to the investor to induce him to purchase a bond with a term not in line with his initial preference. The expectations and segmented-market hypotheses are extreme forms of the preferred habitat theory. Under the expectation hypothesis, the term premium is effectively zero, while under the segmented-market hypothesis the term premium is effectively infinite.

Since the preferred habitat hypothesis combines the expectations hypothesis and segmented-markets hypothesis it has great power to explain the shapes of yield curves. It can explain not only upward sloping yield curves but also flat and downward-sloping yield curves as well. Unlike the other two hypotheses, it can explain why the yield curve slopes upward. It also suggests, as is borne out by empirical studies, that short-run and long-run interest rates move together in the same direction.