Are Corporate Bonds Worth the Risk?
Corporate bonds are riskier than Treasury securities. The reward for accepting this risk is larger when spreads widen, but may be less than investors expect when spreads are modest.
Investors take corporate-bond risk when they believe the reward is big enough to justify the variability in returns. But the reward for taking this risk is inconsistent. Investors should not expect to earn the yield spread between corporates and Treasury securities, and the risk may only be worth taking when the spread is wide enough to deliver a credit premium large enough to justify the risk.
It's common to see the yield spread between corporate bonds and Treasury bonds of a similar duration as an indication of the expected bonus an investor will receive. In fact, it is common in the financial press to use the term corporate bond returns when actually referring to their yields.
On October 7, 10-year Treasury securities yielded 0.81% and AAA corporate bond yield spread on 10-year constant maturity bonds was 1.61% according to the Federal Reserve Bank of St. Louis (FRED).
Does this mean that corporate bond returns will be 1.6% higher?
No. As we will see from the historical data, this is an important mistake that results in disappointment for investors whose future goals are tied to these performance expectations.
Why are yields on corporate bonds higher than on Treasury securities? A simple explanation is that corporate bond returns are riskier and investors need to be compensated for accepting risk (the credit risk premium) and the market expects some firms to go bankrupt or otherwise fail to make future bond payments (for example the embedded option to call bonds). Other explanations include exemption from state income taxes, credit downgrades, or differences in liquidity.