Factors Affecting Debt Security Yields
Table of Contents
What causes debt securities to have different yields? There are 4 general causes:
- Credit risk
- Tax Status
- Liquidity
- Time left to maturity
1. Credit Risk
Credit risk measures the probability that the issuer may default on the bond. Clearly, a higher risk of default will require a higher yield by the bond buyer.
1.1. NRSROs
When a bond is going to be sold to the public (as opposed to a private placement) its credit risk must be rated by a Nationally Recognizes Statistical Rating Organization. These are informally known as credit ratings agencies. Note, NRSROs only evaluate the bond's credit risk, and not its interest rate or liquidity risk. Different NRSROs have different rating scales, however generally they range from something like AAA to D.
There are a couple of known issues when it comes to credit ratings:
- The bond issuer pays the ratings agency, so there is a conflict of interest and pressure to give high ratings.
- The track record of credit ratings is fairly poor. During the 2008 crisis some bonds rated AAA defaulted.
A fairly accurate representation of these issues is shown in the movie The Big Short.
Despite a lackluster track record, credit ratings are meaningful because many funds and investors cannot invest in anything below investment grade securities. The investment grade threshold is Baa by Moody's and BBB by S&P. Bonds with ratings below these thresholds are known as high-yield or junk bonds and your typical bond mutual fund cannot invest in them.
2. Tax Status
Investors care about after-tax and not before-tax yield—there is no utility found in paying taxes. Therefore when investors compare debt investments, they only compare the after-tax yield, which may be calcualted as:
\[y_{at} = y_{bt} (1 - \tau)\]
where:
- \(y_{at}\) is the after-tax yield
- \(y_{bt}\) is the before-tax yield
- \(\tau\) is the investor's marginal (total) tax rate.
So, for example, if a bond has a yield of 10%, and your tax rate is 30%, the after tax yield is \(0.10(1-0.03) = 0.07\) or 7%.
You can also gross-up an after tax yield to determine the before tax yield you would have to offer investors such that your bond is attractive.
\[y_{bt} = \frac{y_{at}}{(1 - \tau)}\]
2.1. Tax Rates of Various Bond Types
First, note when calculating your tax rate we include all relevant taxes—local, state, and federal. Your tax rates can vary substantially because:
- Municipal bonds interest can be exempt from local, state and federal taxes.
- Treasury bonds interest are exempt from state and local taxes.
- Corporate bond interest is usually always taxable.
3. Liquidity
Less liquidity demands a higher yield. If there are higher transaction costs, and it is harder to sell the bond, you demand a higher yield.
See LTCM on vs off-the-run bond trade [TODO: find a link or youtube video on the trade-—or create one]
4. Time to Maturity
5. The Final Yield
To value a given bond1 we start with the rate on a treasury with the same maturity, and then adjust this yield for default risk, tax status, and liquidity. For example, say we want to value a 10-year corporate bond, and the rate on a 10-year treasury note is 4%.
We then start with 4%, and then increase the rate for default risk and tax status. Remember a corporate bond may default and also incurs more taxes. Lastly, we would increase the rate for lower liquidity in the corporate bond. We may end up with a yield of something like 4.7% for the corporate bond.
Note the adjustments are not always positive. If it were a municipal bond, we may lower the yield for the preferential tax treatment.
Footnotes:
We state the value of a bond by its rate and not its price. To review why see this presentation.