Why Corporate Bonds Have Higher YTM Than Treasuries

Imagine you are considering two different types of investments. Let’s say you have the option to lend your money to the government or to a corporation. Lending to the government, specifically the US government through Treasury bonds, is generally seen as one of the safest investments in the world. Why? Because the US government is highly unlikely to default on its debts. Think of it like this: lending money to the most stable and reliable person you know. The risk of them not paying you back is very low.

Now, consider lending money to a corporation by purchasing a corporate bond. Corporations, unlike governments, can and sometimes do go bankrupt. This means there’s a chance they might not be able to pay back the money they borrowed, including the interest. This risk of not getting your money back is called credit risk or default risk. It’s like lending money to a business, which, while potentially profitable, always carries a higher risk than lending to a very stable individual.

Yield to Maturity, or YTM, is essentially the total return you can expect to receive if you hold a bond until it matures. It takes into account not just the interest payments, but also the difference between the bond’s purchase price and its face value, assuming you hold it until maturity. Investors use YTM as a way to compare the potential returns of different bonds.

Because corporate bonds carry this inherent credit risk that Treasury bonds largely avoid, investors demand to be compensated for taking on that extra risk. Think of it as an incentive. If you’re taking on a higher chance of losing your money by lending to a corporation, you’ll naturally want a higher potential return to make it worthwhile. This higher potential return comes in the form of a higher Yield to Maturity.

Therefore, to attract investors, corporations must offer higher interest rates on their bonds compared to the government. This higher interest rate translates directly into a higher YTM. It’s the market’s way of pricing in the risk associated with corporate bonds. The greater the perceived risk of a particular corporation, the higher the YTM on its bonds will likely be compared to a Treasury bond of the same maturity.

Consider two bonds both maturing in ten years. One is a US Treasury bond, and the other is a bond issued by a well-known corporation. Because the Treasury bond is considered virtually risk-free, it might offer a YTM of, let’s say, 4 percent. However, to compensate investors for the credit risk associated with the corporate bond, it might need to offer a YTM of, for example, 5 percent or even higher. This extra percentage point or more is the risk premium, the additional return investors demand for bearing the credit risk of the corporation.

This difference in YTM is not arbitrary; it’s a fundamental aspect of how bond markets function. It reflects the principle that higher risk should be rewarded with higher potential returns. The wider the gap in perceived risk between a corporate issuer and the US government, the larger the difference you will typically see in their bond yields. So, when you observe that corporate bonds generally have a higher Yield to Maturity than Treasury bonds with the same maturity, remember it’s primarily because of the added layer of credit risk inherent in corporate debt. Investors are simply being paid more to take on that additional risk.