40 CHAPTER 1 An Overview of Corporate Finance and the Financial Environment
Longer-term corporate bonds are also less liquid than shorter-term debt, hence
the liquidity premium rises as maturity lengthens. The primary reason for this is that,
for the reasons discussed earlier, short-term debt has less default and interest rate risk,
so a buyer can buy short-term debt without having to do as much credit checking as
would be necessary for long-term debt. Thus, people can move into and out of short-
term corporate debt much more rapidly than long-term debt. The end result is that
short-term corporate debt is more liquid, hence has a smaller liquidity premium than
the same company’s long-term debt.
Figure 1-8 shows yield curves for an AA-rated corporate bond with minimal de-
fault risk and a BBB-rated bond with more default risk, along with the yield curve
for Treasury securities as taken from Panel a of Figure 1-7. Here we assume that
inflation is expected to increase, so the Treasury yield curve is upward sloping. Be-
cause of their additional default and liquidity risk, corporate bonds always trade at a
higher yield than Treasury bonds with the same maturity, and BBB-rated bonds trade
at higher yields than AA-rated bonds. Finally, note that the yield spread between
FIGURE 1-8 Corporate and Treasury Yield Curves
Interest Rate
(%)
12
10
8
6
4
2
0 10 20 30
Years to Maturity
BBB-Rated Bond
AA-Rated Bond
Treasury Bond
Interest Rate
AA Spread BBB Spread AA Spread
Term to Maturity Treasury Bond AA-Rated Bond over T-Bond BBB-Rated Bond over T-Bond over BBB
1 year 5.5% 6.7% 1.2% 7.4% 1.9% 0.7%
5 years 6.1 7.4 1.3 8.1 2.0 0.7
10 years 6.8 8.2 1.4 9.1 2.3 0.9
20 years 7.4 9.2 1.8 10.2 2.8 1.0
30 years 7.7 9.8 2.1 11.1 3.4 1.3
38 An Overview of Corporate Finance and the Financial Environment
