Corporate bonds and U.S. Treasury bonds are two types of fixed-income securities that investors can choose to invest in. The main difference between the two is that corporate bonds generally offer higher yields than U.S. Treasury bonds. For example, on June 30, 2022, the benchmark 10-year U.S. Treasury bond carried an effective yield of 2.97%, while the median yield on corporate bonds within the ICE BofA U.S. Corporate Index maturing in 2032 was 4.87%. This difference in yield is referred to as the spread-versus-Treasuries (SVT) and is usually expressed in basis points, with each basis point being equivalent to 1/100 of a percentage point. Therefore, on June 30, 2022, the SVT was 1.90 percentage points or 190 basis points.
While receiving a higher yield may seem attractive, investors who choose corporate bonds over U.S. Treasury bonds are taking on greater risks. Two major risks that corporate bondholders face are default risk and illiquidity risk.
U.S. Treasury bonds are often considered "risk-free" because investors do not typically face the risk of default - that is, the risk that the issuer will fail to meet its interest payments and principal repayment obligations. However, Treasury bonds do carry interest rate risk, which refers to the risk that bond prices will fall if yields rise. This risk can be significant, as Treasury bond yields can fluctuate widely over long periods and even on an intra-day basis.
On the other hand, corporate bonds do carry default risk, which is the risk that the issuer will fail to meet its interest payments and/or principal repayment obligations. The likelihood of default varies depending on the creditworthiness of the issuer and the quality of the bond. For medium- to high-quality bond issuers (such as those included in the ICE BofA U.S. Corporate Index), the incidence of default within one year between 1970 and 2022 was 0.1% or one in 1,000, increasing to 5.3% or about one in 20 over a 20-year period. Despite the relatively low likelihood of default for investment-grade corporate bonds, investors are still compensated for taking on this risk through a higher yield premium over comparable-maturity Treasury bonds.
The default risk that investors face is not only a function of the probability of default but also the expected loss in the event of default. Typically, bondholders do not lose their entire principal when an issue defaults, and the default-related portion of a bond's spread-versus-Treasuries is estimated as Probability of Default x (1 – Expected Percentage Recovery of Principal).
In addition to default risk, investors in corporate bonds also face illiquidity risk, which is the risk that they may not be able to sell their bonds when they want to or at the price they want. The market for U.S. Treasury bonds is widely regarded as the world's deepest, with issues changing hands every day the market is open. In contrast, many corporate bonds may go days at a time without trading, and bid and ask quotes for them may show wide differences between prices. As a result, the market compensates investors in corporate bonds for this lower marketability by offering a yield premium over comparable-maturity Treasury bonds.
Credit ratings are an important consideration when investing in corporate bonds. Credit rating agencies such as Moody's and Standard & Poor's rate bonds based on their creditworthiness and assign ratings that reflect the estimated default risk. Bonds with higher ratings are considered to be lower risk and typically offer lower yields, while lower-rated bonds are considered higher risk and typically offer higher yields.
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