Say two five-year bonds sit side by side: a corporate bond yielding 5.5% and a Treasury yielding 4%. Why does lending to the company offer another 1.5 percentage points?
The extra yield looks appealing on a quote screen. Collecting it depends on the business behind the promise. The company must find cash for every payment; a contract cannot manufacture it.
A company must find the cash
Credit risk is the risk that a borrower fails to meet its debt obligations. A bond default is that failure, such as a missed interest or principal payment.
Harbor Coffee, our fictional Consumer Staples business, sells packaged coffee and runs shops. Sales bring in money; beans, wages and equipment use it up. A lender cares about what's left for debt payments. A profitable headline cannot pay a bill.
That means looking at cash coming in, cash already available and debt coming due. A company may afford this year's interest and still struggle with the much larger repayment at maturity. Debt and leverage adds financial ratios if you want to examine that evidence more closely.
After default, recovery is what a creditor ultimately receives. Bond seniority is your place in the repayment line. Collateral is property pledged to secure the debt.
Bonds rank ahead of common shares, but other creditors can rank ahead of your bond. Being nearer the front of the line does not make the pot of money bigger.
Where investment grade ends
A credit rating is an agency's opinion of creditworthiness: the borrower's ability to meet its obligations. Agencies can disagree, and ratings can change. A rating neither recommends a purchase nor predicts the bond's price or sensitivity to interest rates.
On the S&P and Fitch long-term scales, ratings descend from AAA through AA, A, BBB, BB, B and lower. The key boundary is between investment grade and high yield:
| Grade | S&P / Fitch | Moody's | Assessed credit risk |
|---|---|---|---|
| Investment grade | BBB− and above | Baa3 and above | Lower |
| High yield | BB+ and below | Ba1 and below | Higher |
High yield is also called speculative grade or junk. Investment grade means lower assessed credit risk, not a promise that you will be repaid. An unrated bond has no agency grade; it is not automatically a junk bond.
An issuer rating assesses the borrower's overall creditworthiness. An issue rating covers a specific bond, whose collateral and seniority can lead to a different grade. Two bonds from the same company can deserve different ratings.
The spread is the market's price
A credit spread is the extra yield over a Treasury with similar time remaining. Our five-year example uses US-dollar bonds with fixed payments and no early-redemption option. Both quotes use the same yield-to-maturity convention at the same moment.
Here, 5.5% − 4% = 1.5 percentage points, or 150 basis points. One percentage point equals 100 basis points.
Suppose the corporate yield rises to 7% while the Treasury stays at 4%. The spread becomes 7% − 4% = 3 percentage points, or 300 basis points: 150 wider. Only the spread portion grows in the figure.
With the coupon unchanged, the higher yield comes from a lower price. The owner gets no extra cash, and prices can move before a rating agency changes a single letter.
Investors demand more yield when repayment looks shakier or a bond becomes harder to sell without a steep discount. Contract features and investors' willingness to bear uncertainty also affect spreads. A 300-basis-point spread does not mean a 3% chance of default.
Widening across many companies can signal concern about credit or difficulty trading. It is no reliable recession countdown.
A corporate yield can even fall while its spread widens if Treasury yields fall farther. The gap and the total yield answer different questions.
Extra income can meet a bigger loss
Take a separate bond with $1,000 face value, bought for $1,000. Suppose it defaults and you ultimately recover 40% of face value. That percentage is the recovery rate; we chose 40% for easy arithmetic.
- Recovered principal: $1,000 × 40% = $400.
- Principal lost: $1,000 − $400 = $600.
That is the principal loss before coupons, taxes, costs or the effect of waiting for recovery. The chance of default is only part of credit risk. How much comes back afterward matters too.
High-yield bonds carry greater default risk and usually offer more yield than comparable investment-grade bonds. In a downturn, weak business cash flows threaten bond payments and shareholders' profits together. That is why high-yield bonds can fall alongside stocks. Diversifying through bond funds reduces dependence on one borrower, but cannot remove losses shared across many businesses.
Return to the 7% corporate quote beside the 4% Treasury. The spread has doubled. Is that extra yield safe to count on?
No. You still need to know who's borrowing, what cash can cover repayments, your bond's seniority and collateral, and which agency rated it and when. The SEC's rating guide explains why the company's finances and the bond's documents belong alongside the grade.
Evidence of dependable cash and a well-secured claim could make the extra yield more attractive. A business running short of cash could explain why buyers demand it. Until you know which story fits, a wider spread is a reason to investigate.
The Treasury yield stayed at 4% here to isolate the spread. Duration puts a size on price sensitivity when market yields change, even for a strong borrower.
In short
- Extra promised yield is compensation for risk, not an assured bonus.
- A rating is an opinion about repayment, not a guarantee or a price forecast.
- A wider spread can lower a bond's price before any default or downgrade.
- Recovery can leave you with only part of the principal you lent.
- Strong credit quality does not eliminate interest-rate risk.