Long Term Perspective

The 10-year Treasury note, rather than the 30-year bond, has become the benchmark security from which corporate interest rate levels are derived.  All corporate bond yields in the charts below are rated by Citigroup Global Markets. Triple A rated bonds have the lowest risk of default, whereas Triple B bonds have the highest default risk among this group. Triple B bonds can be considered junk bonds, although distressed bonds are also rated “C” by some rating agencies.

Investors choose the amount of risk that they can tolerate. Those with low risk tolerance would choose the Treasury security for the lowest default risk, while investors with high risk tolerance might prefer the Triple B instrument with the highest default risk. A lower default risk comes with a lower yield; conversely, the higher the default risk, the higher the yield.

The spreads between Treasury securities and corporate bond yields are not uniform over the business cycle. Spreads widen during recessions when default risk is higher for all corporate bonds. Spreads narrow during boom times because default risk for all bonds diminishes when the economy is healthy.

Note: Citigroup’s rating scheme differs from that of Moody’s.  Moody’s broad categories begin with a capital letter (A, B, or C with A being the highest quality and lowest credit risk). Each broad category is differentiated into further subdivisions with a lower case “aa,” “a,” or no additional letter.  For Moody’s, the following are in descending order of quality – Aaa, Aa, and A. According to Moody’s, obligations rated Aaa are judged to be of the highest quality, with minimal credit risk. 

Short Term Perspective

Typically, Treasury securities have the lowest risk – and therefore the lowest yields. This was not always true between 2002 and 2005, although the 10-year Treasury note had a lower yield from mid-2005 into early 2009. The divergence in spreads is sometime due to the corporate rate including shorter maturities, which generate lower yields than those securities with longer maturities. The spread between average AAA/AA corporate bond yields and the 10-year note rose to minus 43 basis points in 2011 from minus 83 basis points in 2010.

Somewhat more recently, the spread between average AAA/AA corporate bond yields and the 10-year turned positive in September 2011 as the T-note fell on the Fed announcing it Maturity Extension Program, also known as “Operation Twist.”  But the spread declined from 25 basis points in September to merely 2 basis points in January. The 10-year Treasury yield was down 1 basis point in January at 1.97 percent while the AAA/AA corporate yield declined 22 basis points to 1.99 percent. 

On an annual average basis, the spread between average A corporate bond yields and the 10-year note rose to 80 basis points in 2011 from 58 basis points the year before.  Finally, the spread between average BBB corporate bond yields and the 10-year Treasury note rose 157 basis points in 2011 from 140 basis points in 2010. This spread remained high in 2009 because of flight to quality and concern about increased credit risk.  Spreads came down in 2010 and into early 2011 as economic data suggested an improvement in the recovery.  But a soft economy and flight to safety (Treasuries) led the spreads to rise in mid and latter 2011.  But in 2012, corporate rates also eased, bringing spreads down.

In October, the spread on AAA/AA bonds declined to minus 25 basis points. The spread for A corporate bonds in October decreased to 59 basis points while that for BBB corporate bonds eased to 145 basis points.  For the month, the AAA/AA rated yield dipped 5 basis points to 1.50, the A corporate bond yield declined 10 basis points to 2.34 percent while the rate on the BBB corporate bond decreased 13 basis points to 3.20 percent.