Question

Compare the most recent 30 yearTreasury Bond rate with the Corporate Bond rate for Aaa and Baa ratings and the State & local bonds (municipal bonds). Why would someone choose one of these bonds over the other as an investor? Explain.

Answer 1

Because the option to call a corporate bond should rise in value when bond yields fall, the relation between noncallable Treasury yields and spreads of corporate bond yields over Treasury yields should depend on the callability of the corporate bond. I confirm this hypothesis for investment‐grade corporate bonds. Although yield spreads on both callable and noncallable corporate bonds fall when Treasury yields rise, this relation is much stronger for callable bonds. This result has important implications for interpreting the behavior of yields on commonly used corporate bond indexes, which are composed primarily of callable bonds.

The risk structure of interest rates explains why bonds of the same maturity but issued by different economic entities have different yields (interest rates).The three major risks are default, liquidity, and after-tax return. By concentrating on the three major risks, you can ascertain why some bonds are more (less) valuable than others, holding their term (repayment date) constant. You can also post-dict, if not outright predict, the changes in rank order as well as the spread (or difference in yield) between different types of bonds. A flight to quality occurs during a crisis when investors sell risky assets (like below-investment-grade bonds) and buy safe ones (like Treasury bonds or gold).

The low yield on munis is best explained by their tax exemptions. Before income taxes became important, the yield on munis was higher than that of Treasuries, as we would expect given that Treasuries are more liquid and less likely to default. During World War II, investors, especially wealthy individuals, eager for tax-exempt income and convinced that the fiscal problems faced by many municipalities during the depression were over, purchased large quantities of municipal bonds, driving their prices up (and their yields down). Almost all the time since, tax considerations, which are considerable given our highest income brackets exceed 30 percent, have overcome the relatively high default risk and illiquidity of municipal bonds, rendering them more valuable than Treasuries.