← Money Lessons with Andrew Temte, PhD, CFA
Money Lessons with Andrew Temte, PhD, CFA
Why Some Bonds Pay More: Understanding the Risk-Return Tradeoff
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Foreign. Hi, I'm Andy Tempte and welcome to Money Lessons. Join me every Saturday morning for bite sized lessons that are designed to improve financial literacy around the world. Today is January 31, 2026. Last week we explored the different ways to measure yield. Nominal yield, current yield, yield to maturity, and yield to call. We discovered that comparing the yields is essential for evaluating bond investments. But here's the question we haven't answered yet. Why do different bonds offer different yields in the first place? Well, today we're exploring the landscape of bond types, from the safest government securities to the riskiest corporate debt and discovering how the bond market prices risk. We have to start our discussion with treasury bonds. These are bonds issued by the US Federal government. Treasuries are considered the safest bonds in the world because they're backed by the full faith and credit of the United States Government. The government can always raise taxes or in extreme circumstances, print money to pay its debts. This perceived safety makes treasury yields the benchmark against which all other bonds are measured. When financial professionals discuss the risk free rate, they're referring to treasury yields. When you hear on the news that the 10 year treasury is yielding 4.5%, that's the baseline return investors can earn with virtually no credit risk, no concern that the borrower won't repay. Importantly, this represents the risk free rate for a 10 year investment horizon. Different maturities have different risk free rates. A two year treasury will have a different yield than a 30 year treasury, reflecting varying expected market conditions over those time periods. We'll discuss this more in future episodes when we introduce the concept of the term structure of bonds. But here's the trade off. Safety comes at a price. Because Treasuries carry minimal risk, they offer relatively low yields. Investors willing to accept more risk can earn higher returns elsewhere. So when corporations borrow money by issuing bonds, investors face a risk that treasury investors don't. The company might fail to pay. A corporation can go bankrupt. Its profits can disappear in challenging market conditions or in times of poor strategic execution. Unlike the government, it can't print money to cover its debts. To compensate for this additional risk, corporate bonds must offer higher yields than Treasuries. The difference between a corporate bond's yield and a Treasury bond's yield of similar maturity is called the the credit spread. Oh, so now I've got a necessary financial jargon alert. Bond professionals express credit spreads in basis points rather than percentages. One basis point equals 1100 of a percentage point. So 100 basis points equals 1%. Why bother with basis points because bond yields move in very small increments. Saying a spread widened by 25 basis points is clearer than saying that it widened by 0.25 percentage points. Historically, investment grade corporate bonds or those with strong credit ratings have offered yields averaging about 130 basis points, or 1.3% above above comparable treasuries. If a 10 year treasury yields 4.5%, an investment grade corporate bond might yield around 5.8%. Now, not all corporate bonds carry the same risk. Credit rating agencies like Moody, Standard Poor's and Fitch evaluate bond issuers and assign ratings that help investors assess creditworthiness. We introduce these agencies back in our December 27 episode on corporate bonds. A critical dividing line separates investment grade from high yield debt. So investment grade bonds are rated triple B minus or higher by S&P and Fitch, or B AAA 3 or higher by Moody's. These companies have adequate financial strength to meet their obligations under normal economic economic conditions. Now, high yield bonds are bonds that are rated BB or lower by S&P and Fitch, or Ba1 or lower by Moody's. You might also hear these bonds called junk bonds, though that term has fallen a bit out of favor these days. These bonds they come from companies with weaker finances, higher debt loads and less stable cash flows. High yield bonds offer substantially higher yields to compensate for their elevated risk. While investment grade spreads average around 130 basis points, high yield spreads have historically averaged about 450 basis points, or 4.5% above treasuries, and can range much higher than that during times of economic stress and uncertainty. If that same 10 year treasury yields 4.5%, a high yield corporate bond might yield 9% or more. That extra return sounds really attractive, but it comes with significantly higher risk of default. Now, we can't talk about bond types without talking about municipal bonds or munis for short. These are bonds that are issued by state and local governments to finance public projects like schools, roads and water systems. They occupy a unique position in the bond market because of one crucial feature. Their interest payments are typically exempt from federal income tax, and in some states, municipal bond interest is also exempt from state taxation. This tax exemption changes how investors should evaluate municipal yields. A municipal bond yielding 3.5% might actually provide more after tax income than a taxable bond yielding 4.5%, all depending on your tax bracket. To compare fairly, investors calculate what's called tax equivalent yield or the yield a taxable bond would need to offer to match a municipal bond's after tax return. For investors in high tax brackets, municipals can offer compelling value despite their lower stated yields. Now I want you to picture the bond market as a spectrum running from lowest risk to highest risk. At the low end of the spectrum are treasury bonds. These are the lowest risk, lowest yield, and they are the benchmark against which everything else is measured. Measured. Then in the middle we have investment grade corporates and most municipal bonds. These offer modestly higher yields in return for modestly higher risk. And then on the high end of the spectrum, you've got high yield bonds, which offer significantly higher yields but with meaningfully elevated default risk. This relationship between risk and return is fundamental to all investing, not just bonds. Greater potential reward requires accepting greater risk. There is no free lunch. You can't earn high yield returns with treasury level safety. Understanding where different bonds fall on the spectrum helps you make more informed choices. A conservative investor nearing retirement might favor Treasuries and investment grade corporate debt. A younger investor with decades to recover from setbacks might allocate some portion of their portfolio to high yield bonds. Now we've established that riskier bonds must offer higher yields. But what determines exactly how much higher? Why does one corporate bond yield 150 basis points above treasuries while another yields 500? The answer lies in credit analysis, the detailed evaluation of a borrower's ability to repay. Next week, we'll explore how credit ratings work, what causes ratings to change, and why understanding credit risk is essential for bond investing. Until next week, I wish you grace, dignity and compassion. My name is Andy Tempte. This is Money Lessons. You can find the show on all the major streaming services as well as out on YouTube. Please like subscribe, rate, and most importantly, share this public good with your friends, your family, your neighbor, and maybe a colleague at work. The show was produced by Nicholas Tempte, and we'll see you next time on Money Lessons.