Bonds course · Lesson 3 of 7
A higher yield is a promise, not a return.
A Treasury bond pays what it promises. A corporate bond can fail to pay. The extra yield, called the spread, pays for that risk. Part of it is not a return at all.
Yield is what the bond promises
The yield of a bond assumes that every payment arrives. If the company defaults, you get back only part of your money. So the expected return is lower than the yield.
| Example | Value |
|---|---|
| Treasury yield | 4.0% |
| Corporate bond yield | 5.5% |
| Spread | 1.50% |
| Default rate a year (example) | 0.5% |
| Recovery after a default (example) | 40% |
| Expected loss a year | 0.30% |
| Expected return | 5.20% |
| Extra return over the Treasury | 1.20% |
In the example, 0.5% of these bonds default each year, and holders get back 40% of the face value. The expected loss is 0.5% times 60%, or 0.30% a year. The rest of the spread, 1.20%, is the extra return for the risk.
The default rate that uses up the spread
Divide the spread by the share that you lose in a default. For the example, 1.5% divided by 60% is 2.5%. If more than 2.5% of such bonds default each year, the corporate bond does worse than the Treasury.
When the risk arrives
Defaults rise when the economy is weak. That is often when stocks fall too. So a corporate bond can lose value at the time when you most need your bonds to hold steady. A Treasury does not have this risk.
One default on a $10,000 bond with 40% recovery costs $6,000. That takes many years of a 1.5% spread to earn back. So spread the risk across many issuers, or use a fund.
Key points
- The yield assumes that every payment arrives. The expected return is lower.
- Expected loss is the default rate times the share that you lose.
- Divide the spread by the share that you lose to find the default rate that uses it up.