Required Rate of Return on a Bond

The required rate of return on an investment is the return earned on the purchase of the asset that offsets the overall level of investment risk. Put another way, the required rate of return on a bond is the return that a bond issuer must offer in order to entice investors to purchase the asset. The required rate of return is a function of the market’s risk-free rate, plus a risk premium specific to the individual issuer. Bonds are usually considered a less risky investment than stocks because bond holders typically have first rights to corporate cash flows in the event of financial distress. Also, bonds with a longer time to maturity are considered to have a higher risk and thus a higher required rate of return compared to bonds closer to their maturity.

Government-issued bonds are considered to have the lowest risk and therefore the lowest required rate of return. U.S. Treasury bonds, for example, have the full faith and backing of the federal government. The strength of that guarantee is what makes them safer than any other type of bond. International investors, however, judge the risk of governments around the world differently, depending on their credit rating and political risk. So, bonds issued by the government of other countries have varying levels of risk.

Investors in municipal bonds, or munis, assess the required rate of return based upon the credit rating of the municipality issuing the bonds. Munis are considered riskier than bonds issued by the federal government. They typically have a lower required rate of return compared to many corporate bonds since investors do not have to pay state or local tax on the income earned from their investments in the municipal bonds.

Corporate bonds have the highest risk and therefore the highest required rate of return. Corporate credit ratings, as well as bond provisions impacting the investors' rights, both impact perceived risk of the cash flows. Corporate bonds, however, still have a lower required rate of return than stock issued from the same corporation.