Treasuries and corporate bonds are two types of investments ruled by interest rates. The interest rate on corporate bonds will always be higher due to the increased risk of default. Treasuries are less likely to default because of the guaranteed safety in investing with a world power like the United States. If the country does end up in a bind, they could also just print out money to guarantee a return, whereas a corporation does not have that same ability. While Treasuries and corporate bonds will not have the same interest rate 99.99% of the time, any movements in the fed funds rate will affect both investments in the same manner.
The interest rate on a Treasury is assigned by the FOMC, and they are usually divided into three categories. Treasury Bills have the shortest maturity of less than a year and do not pay a fixed interest rate. Instead they are issued through a bidding process at a discount from par. Treasury notes have maturity between one and 10 years, and have a fixed-interest rate set by the Federal Reserve. Treasury bonds have a maturity of more than 10 years, and also have a fixed interest rate. As the interest rate rises, the price of treasuries fall consistent with other types of bonds. Because the return on these investments is so low, they’re normally seen as the safest type of investment and one of the best places to store money in order to avoid market risk.
Corporate bond rates have a higher interest rate than Treasuries, but depending on the issuer can still be seen as a safe investment. The interest rate and yield corporate bonds offer is dependent on their rating. Ratings higher than BBB can be considered investment grade and will have relatively low interest rates, with the lowest coming from any issuer with a rating of AAA (equal to that of the U.S government). Ratings lower than BB are seen as sub-investment grade and have high interest rates. Like any other bond, when interest rates fall the price of the bond will rise and vice versa. This means that corporate bonds are still subject to any fluctuation in the interest rates set by the Fed, even though they are not a direct reflection of Treasuries. Corporate bonds are inherently riskier because they do not have the guarantee of the U.S Government and will always have a higher interest rate even if the issuer has a low default risk
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Good. I’ll show in class how to find and do this in a cleaner way using FRED.
Checking here whether “markdown” language works in to give links in comments.
Or allows images – NO. Not in comments.
One question that I have is whether or not there is a consensus drop-off point in corporate credit ratings, where firms are generally assumed to be a safe bet in repaying debt. In the eternal search for higher yield, is there a point (say, where investment grade ratings end), where assets are seen as having an acceptable yield while avoiding lower risk? In other words, is the corporate bond market an environment which more closely resembles a smooth continual trade-off between yield and risk, incrementally transitioning with each level in credit rating? Or, is there a market difference in the step from BB to BBB, where most investors go for assets just above a sort of “safe” line? Forgive me if this is an example of arbitrage, as I’m still trying to get my head around the concept.
Firms pay to get a credit rating. To the rating agency. Big conflicts of interest!! In addition, ratings are based on historical data. During the pre-2007 expansion default rates fell and fell, controlling for an array of factors. As a result, credit ratings rose. The historical base however proved to not have a big downturn in it (or in some cases no downturn at all). Economic models do poorly at forecasting far out of the range of available data, that is, predicting who will default is hard when (i) no one has defaulted in a while in (ii) an economy that has evolved and (iii) the negative shock is really big. In the big expansion lots of people developed gooooood ratings. Too good to be true. But the rating agencies made a lot of money.
In short, credit ratings are a guide, but need to be used cautiously.
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