AAA vs. BAA Corporate Bonds: Understanding Yield Differences

The credit ratings of AAA and BAA are the two ends of the ratings spectrum for investment-grade corporate bonds as provided by the Moody's rating agency. The yield difference between bonds with these ratings has historically indicated whether the economy was in a period of recession or expansion.

Credit Ratings

The credit-rating agencies Moody's and Standard & Poor's provide credit ratings on bond issuers and their bonds to give investors an idea of the investment reliability of the bonds, concerning the payment of interest and principal. AAA is the highest bond rating and indicates the safest bonds for investors. Bonds rated below BAA -- BBB from Standard & Poor's -- are considered to be non-investment grade. That makes the BAA rating the lowest investment grade rating. The lower the credit rating, the higher the yield a bond will pay.

Typical Yield Difference

If the economy is expanding at a normal rate, the yield spread between AAA and BAA bonds is usually in a range of 0.8 percent to 1.2 percent. From the start of 1960 through the end of 2010, the average spread between the two corporate bond rates was 1.02 percent. Using the monthly data from the Federal Reserve Bank of St. Louis, the minimum spread for that time period was 0.38 percent and the maximum spread was 3.38 percent.

,Economic Recession

Historically, the yield spread between AAA and BAA bonds widens just before or during an economic recession. This event occurs as investors switch to the safer AAA bonds, pushing down the yield for the higher-rated bonds. The money going into the AAA bonds typically comes out of the lower-rated bonds, so the rate on BAA bonds will increase at the same time. As the economy comes out of the recession, investors will start to have more faith in the economy and more money will flow to lower-rated bonds, narrowing the spread.

Bond Investing Considerations

The range of credit ratings from BAA up to AAA encompasses all investment-grade bonds. Even BAA bonds provide investors with a high degree of safety and the risk of default is low. Investors can look at the current spread between the bonds to determine if there is enough interest premium to justify buying the lower rated bonds or stick with AAA- or AA-rated investments. The St. Louis Federal Reserve Bank website provides historical rate information with daily, weekly and monthly time frames for investors who want to use the rate spread in their investment decisions.