From the early 1980s until the late 1990s the term structure of interest rates in Chile was usually downward sloping, particularly for long maturities. We postulate that the explanation is behind liquidity premium of the term structure of interest rates. Based upon a parsimonious theoretical model, we show that the sign of liquidity premium depends on both expected return and risk. For our sample period 1983-1999, investors were willing to hold long-term assets even though their return was relatively lower. This appears to be a consequence of indexation, which reduced risk of long-term bonds as their return was linked to past inflation.