Taxable bonds can be divided into three major camps. U.S. Treasury bonds are the no-default choice and the benchmark for all other bond yields. Investment-grade bonds have a low chance of default. High-yield corporate bonds are the high-risk/high-potential-reward section of the bond world. The rate spread between high-yield and Treasury bonds suggests for investors like you whether the risk is worth the reward.
Bond Credit Quality
Bonds come with credit ratings provided by the rating agencies of Standard & Poor's and Moody's. The S&P ratings from best to worst are AAA, AA, A, BBB, BB, B, CCC, CC and C. Moody's uses a similar ratings ladder, except it uses a lowercase "a" after the first letter. For example, Moody's Baa is the same as an S&P BBB rating. More to the point, bonds with ratings of BB and lower are categorized as noninvestment grade. Bonds at these levels pay a significantly higher rate of interest, and these bonds make up the high-yield market sector.
How Much Yield
The difference between an average yield on high-yield bonds and on U.S. Treasury bonds is the high-yield vs. Treasury credit spread. The spread is a better indicator of the high-yield market than just looking at yields in isolation. For example, if Treasuries are yielding 3 percent and high-yield bonds 8 percent, the spread is 5 percent -- 500 basis points in bond jargon. Compare that to a scenario of Treasuries at 6 percent and high yield at 9 percent for a 3 percent spread. In the first example, investors are paid more on a risk-adjusted basis, as indicated by the 5 percent spread, than with the higher 9 percent yield in the second example.
Finding the Spread
The Treasury vs. high yield spread is most useful in historical context. Investors want to know where the spread is now compared to averages and extremes in the past. To find a chart of the spread, you can use the same data the financial publications use to create a nifty chart for a web page. The St. Louis Federal Reserve Bank offers the FRED economic data tool that lets you produce graphs of a wide range of data. The "BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread" chart shows spread data going back to the mid 1990s.
Although many factors can affect how high-yield bonds perform, many savvy investors avoid buying into high-yield bonds when the spread is small and look closer at the high-yield sector when the spread is wider than average. Over the past 20 years the spread has ranged from about 2.5 percent to greater than 20 percent. If the spread is too narrow, the extra yield from high-yield bonds over safe Treasuries may not be enough to compensate for the added risk. The Treasury-to-high-yield spread plus the current yield of high-yield bonds should both be considered before making a high-yield investment.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.