Short-term interest rates fluctuate according to Federal Reserve monetary policy and market reaction to economic events. Long-interest rates fluctuate according to market forces of supply and demand in relation to economic outlook. Within this framework, bonds issued by different companies carry interest rates that are based on the credit quality of the issuing company, the amount of time to maturity and the type of bond issued.
All bonds trade on a spread to Treasuries of similar maturities. This means that an AAA-rated corporate bond with a 10-year maturity would be priced to yield approximately 65 to 70 basis points more than a 10-year Treasury bond. Ten-year bonds rated A would require a yield spread of approximately 95 to 100 basis points over the 10-year Treasury and BBB-rated bonds would yield approximately 140 basis points more. These spreads change according to economic conditions. When economic conditions are difficult, the market requires a greater yield spread on corporate bonds over Treasuries because of the additional risk of a bad economy affecting the financial health of corporations. During good times, the spreads narrow.
In 1909 John Moody created a system of rating individual companies according to their creditworthiness. Since then, Moody's and Standard & Poor's have become the recognized authorities on bond credit ratings. They assign credit ratings starting with the highest at AAA, and proceeding lower with AA, A, BBB for investment-grade bonds and BB, B, CCC and lower for junk bonds. Each bond trades according to its credit rating, which depends on the creditworthiness of the issuer and the particulars of each bond's individual offering. The credit rating combined with the maturity of the bond dictate the interest rate the bond must pay. During bad economic times, the lower credit ratings will demand a larger spread to Treasuries because those issuers are more likely to experience financial difficulties and the higher interest rate reflects that likelihood.
Boom times and recessions, geo-political strife or peace and changes in technology all affect the interest rate a bond must yield. These variables are how the marketplace values bonds, and these market-dictated bond values change as the variables change. When a company issues a bond, it is best to issue it during a peacetime prosperous economy because this is when the spreads to Treasuries will likely be narrow. If a company specializes in making electric typewriters, and the personal computer arrives on the scene -- as happened in the early 1980s -- the rating for the typewriter company declined as it lost business to PC workstations. The market soon required higher yields -- wider spreads to Treasuries -- to attract buyers to the bonds.
All these details describe the complex way the marketplace prices bonds relative to their perceived risk. The greater the risk of default, the higher the market-dictated yield. Similar companies with similar credit ratings might each issue a 10-year bond. Because of the market-perceived differences between the two companies, the bonds of one company will easily sell at a certain rate while the bonds of the other company will have to yield a few basis points more to attract buyers. The difference is market perception of value.
- Securities Industry and Financial Markets Association: How Do Credit Ratings Affect Yield?
- Financial Policy Forum; Credit Rating Agencies: Their Impact on Capital Flows to Developing Countries; Gautam Setty and Randall Dodd; April 2003
- Moody's Investor Services: Ratings Definitions
- Bonds Online: US Corporate Spreads
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