The Difference between Corporate Bonds and Treasuries

Bond investors should understand the difference between Corporate Bonds and Treasuries. Below is a list of the key differences between the two.

Corporate issuers have ratings across the full ratings spectrum, from top AA-rated investment grade companies to CCC rated companies at the bottom of the sub-investment grade world. On the other hand, Treasuries are issued by the U.S. Treasury and are therefore rated the same as the U.S. government, currently at AA+ after being downgraded during Fall 2011. Nonetheless, a AA+ rated Treasury is generally considered safer than similarly rated corporate bonds.

Since Treasuries are considered the safest asset available, their returns are close to the risk free rate. Currently the 10 year Treasury pays close to 2%. Below investment grade corporate bonds (known as high yield bonds) can pay 4-5% for a BB rated bond and even above 10% for CCC rated bonds. Investment grade corporate bonds would fall between Treasuries and high yield bonds.

Both Treasuries and corporate bonds pay fixed coupons and are therefore vulnerable to interest rate (e.g. the Federal Reserve Rate) fluctuations. When interest rates go up, bond prices fall and vice versa. The price dependence (called duration) increases as maturity of the bond increases.

Treasuries vary in maturity, from a few months (e.g. Treasury Bills), a few years (e.g. Treasury Notes) and up to 30 years (e.g. Treasury Bonds). Investment grade corporate bonds are available in similar maturities, from a few years up to 30 years. High yield bonds usually range between 7 and 10 years, with shorter maturities being possible but generally reserved for lower rated issuers and longer maturities being more rare in general in the U.S. market.

Treasuries are far less volatile than corporate bonds since the latter fluctuate based on the earnings of the issuer. While some investors may dislike volatility, the higher yield of corporate bonds is meant to compensate for it plus the price fluctuations may allow an investor to time entry and exit prices.

Treasuries are considered risk-free instruments since they are backed by the U.S. Government and are therefore as good as cash. This would mean any other investors would be willing to buy them when an investors wishes to sell. In the U.S. the corporate debt market is very liquid as well; while transaction costs (e.g. bid-ask spread) may be higher, they are not prohibitively so. Besides, ETF investors do not need to worry about individual bonds and instead should focus on their ETF’s liquidity.

Treasury ETFs are generally divided by maturity; iShares has a full suite of options: SHY (1-3 years), IEI (3-7 years), IEF(7-10 years), TLH (10-20 years) and TLT (20 years).

On the investment-grade bond side, the largest ETF is iShares LQD. Additionally, since longer maturity bonds are more sensitive to interest rate variations (known as higher duration risk), there are also several options available based on maturity: CSJ (1-3 years), VCSH(1-5 years) and CIU (1-10 years).

Well known high yield bond ETFs include HYG, JNK and PHB, each tracking their own benchmark of the most liquid high yield bonds in the USD market.