A Look at Corporate Bond Yields

The two biggest factors that affect corporate bond yields are rating and spread to treasuries. Between these two considerations, you can see how a given company’s debt compares to the debt of other companies, and how that quality of debt relates to treasuries. By locating a corporate bond within a rating class and determining the spread to bonds issued by the U.S. Government, you will be able to get a good sense of what a specific bond ought to yield.

The Meaning of Bond Ratings

The bonds of most traded companies receive a rating from one of the major rating agencies – Standard & Poor’s, Moody’s, and Fitch. While the specific naming conventions differ slightly, most use a combination of letters to denote rating. AAA bonds of the highest quality, followed by AA, the A, the BBB, and so on. Bonds with a rating of BBB or better are called investment grade. This means they have a relatively low probability of default and are reasonable investments. Lower rated bonds are consider speculative and must pay a higher rate to offset significant default risk.

Bond ratings are determined by considering a wide variety of factors. These include the health of the company, the capital structure, the industry, the history, as well as many others. The goal is to make an assignment that will allow apples to apples comparisons between various bonds. These rating are not guarantees of anything, and are merely a starting point for professional bond traders.

The Yield Curve and Spreads

U.S. Treasury bonds are considered the safest fixed income investment because they are backed by the full faith and credit of the U.S. Government. The yield curve is a graphical depiction of what yield you will receive for each maturity available from the Treasury. This curve shows you the relationship between short-term and long-term rates, and how things shift when major events occur in the economy. Under normal conditions, the curve is upward sloping. This means that longer-term bonds pay more than shorter-term bonds. This is because investors demand additional compensation for agreeing to having their money locked up for longer.

For every bond rating there is also a yield curve. This curve shows the spread, or additional yield, that you will receive by owning corporate bonds instead of treasuries. While not uniform, each of these curves tend to be roughly parallel to the treasury curve. AAA bonds yield more than treasuries, and each successively lower bond rating yields more. The extent of these spreads is not fixed, and you will notice a significant spread between investment grade bonds and the next lowest rating.

The reason for these spreads is that investors demand compensation for taking additional risk. If you are going to lend money to a less reliable company, you will only being willing to take this risk if you receive a better return. What you can see then is that the longer the maturity and the lower the rating, the higher the yield. Locating a given corporate at the proper maturity and on the proper rating curve will give you a very accurate idea of what the bond will yield.

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