The yield difference between corporate bonds and Treasury bonds of the same maturities is referred to as the yield spread or yield gap. Bond investors often use Treasury bonds as a benchmark to compare with corporate bonds. Backed by the full faith of the U.S. government, Treasuries are considered risk-free debt securities, and returns on Treasuries are a reflection of the time value of money. By linking corporate bonds with Treasury bonds, investors need to add only a risk premium to Treasury yield to determine yield on corporate bonds.
Corporate bonds of the same maturity but with different credit ratings have a different yield spread. The higher the corporate bond's credit rating, the narrower the bond yield spread; the lower the rating, the wider the spread. A corporate bond rated AAA is likely to have a narrower yield spread over the yield on Treasury, whereas a junk bond is likely to have a wider yield spread over Treasury. By the same token, if a bond rating is upgraded, its yield spread will narrow; if a bond is downgraded, its yield spread will widen.
Changes in market interest rates may affect bond yield spread. A declining interest rate may narrow yield spread on newly issued corporate bonds, which drives up the price of existing corporate bonds with a wider yield spread and benefits bond holders. On the other hand, a rising interest rate may widen yield spread on newly issued bonds, which pushes down the price of existing bonds with a narrower yield spread, hurting bond holders.
In distinct business conditions during a business cycle, yield spread can also change independent of interest rate change. In an economic downturn, although the interest rate may be coming down, corporate bond yield spread likely widen as investors are more worried about potential corporate default in a slowing economy. In an economic upswing, although the interest rate may be going up, yield spread will likely narrow as investors are less concerned about potential corporate default in a growing economy.
Changes in Treasury yield can indirectly affect corporate bond yield spread. All else being equal, when there is a growing demand for Treasury bonds from investors, Treasury price rises and yield falls, widening the corporate bond yield spread. When there is shrinking demand for Treasury bonds, Treasury price falls and yield rises, narrowing corporate bond yield. However, when taking all other factors into account, changing Treasury yield in one direction may or may not result in yield spread to move in the same direction.
Implications of Yield
For corporate bond investors, a narrow or wide yield spread has different implications in terms of both current and future returns. In general, investors should be cautious about yield spread that is too narrow but also be careful about wide yield spread unless the risk from the high yield is acceptable. A corporate bond with a narrow yield spread offers relatively low yield return at purchase and if the yield spread widens, investors holding the bond will see bond price fall, reducing their bond values. A corporate bond with a wide yield offers relatively high yield return when the risk is well assessed, and there is a better chance that the bond yield may narrow, increasing bond price and thus investors' bond holdings.