The Risk Structure of Interest Rates
Bonds of the same maturity can carry different yields. That gap is the risk premium, or spread, and it reflects default risk, liquidity, and tax treatment. The spread over default-free government bonds widens in bad times as investors flee to safety.
Why it matters
Lenders demand extra yield to hold a bond that might not pay, that is hard to sell, or that is taxed more heavily. When the economy turns down, perceived default risk jumps and the spread between risky and safe bonds blows out.
Formulas
Worked examples
During a recession, what happens to the spread between BBB corporate bonds and Treasuries?
It widens. Default risk on corporates rises and investors move to safe Treasuries (a flight to quality), pushing corporate yields up and Treasury yields down, so the spread grows.
Common mistakes
- ✗All bonds of the same maturity yield the same. Default risk, liquidity, and taxes drive a wedge between them.
- ✗Municipal bonds yield less because they are riskier. They often yield less because their interest is tax-exempt, which raises their after-tax appeal.
Revision bullets
- •Same maturity can still mean different yields
- •Spread reflects default risk, liquidity, and taxes
- •Spreads widen in recessions (flight to quality)
Quick check
A flight to quality during a crisis causes the spread between risky and safe bonds to
Connected topics
Sources
- Mishkin (2018), Ch. 6Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.The risk structure of interest rates: default risk, liquidity, and tax effects on yields.