Treasury vs. Corporate vs. Agency Markets Overview

Beginner | Published: 2025-12-29

Why Market Segment Selection Matters

The US bond market totals $58 trillion, but that number obscures a fundamental choice every fixed-income investor must make: how much credit risk to accept for how much extra yield. Treasuries pay 4.5% with zero default risk. Investment-grade corporates pay 5.5-6% with a historical default rate of 0.10% annually. High-yield corporates pay 7-8% but default at 4.2% annually. Agency bonds sit between Treasuries and corporates, offering 5.0-5.2% with near-Treasury safety.

The practical point isn't finding the highest yield. It's understanding exactly what risk you're accepting per basis point of extra return.

The Three Core Segments (What You're Actually Buying)

Treasury Securities: The Risk-Free Benchmark

What they are: Debt obligations of the US government, backed by its full faith and credit (meaning the power to tax and print currency).

Market size: $28.6 trillion outstanding (Q1 2025), representing 60% of all US debt securities. This is the largest, most liquid bond market globally.

The credit profile:

• Default probability: Zero for dollar-denominated debt (the government prints the currency)
• Historical default: None in modern history
• Recovery rate: Not applicable

Yield level (December 2025):

• 2-year: ~4.3%
• 10-year: ~4.5%
• 30-year: ~4.7%

Why this matters: Treasuries are the benchmark against which all other bonds are priced. When someone says a corporate bond yields "150 over," they mean 150 basis points above the comparable Treasury. Your expected return on any bond = Treasury yield + spread. Understanding Treasuries is understanding the foundation.

Agency Securities: Near-Treasury Safety with Extra Yield

What they are: Debt issued or guaranteed by government-sponsored enterprises (GSEs), primarily Fannie Mae, Freddie Mac, and Ginnie Mae. Ginnie Mae carries an explicit government guarantee; Fannie and Freddie carry an implicit guarantee (reinforced by conservatorship since 2008).

Market size: $9.2 trillion in agency MBS alone, with $7.7 trillion in total GSE securities and mortgage loans. Daily trading volume averages $300 billion, second only to Treasuries.

The credit profile:

• Default probability: Near-zero (government has demonstrated willingness to backstop)
• Historical stress test: 2008 crisis resulted in conservatorship, not default
• The implicit guarantee reality: When push came to shove, the government stepped in

Yield level:

• Spread over Treasuries: 50-70 bps historically (currently ~68 bps)
• Current yield: approximately 5.0-5.2%

The key distinction: You're not being paid for default risk with agencies. You're being paid for prepayment risk: when mortgage rates fall, homeowners refinance, and you get your principal back early (precisely when you'd rather keep earning the higher rate). This is a timing risk, not a credit risk.

The practical point: Agencies offer a meaningful yield pickup over Treasuries without material credit risk. For conservative investors who need income above Treasury levels, agencies are the first logical step.

Corporate Bonds: Credit Risk for Yield

What they are: Debt issued by corporations to fund operations, acquisitions, or refinancing. Ranges from AAA-rated blue chips to CCC-rated distressed issuers.

Market size: $11.4 trillion outstanding (Q1 2025). Investment-grade issuance hit $1.5 trillion in 2024 (up 24% from 2023). High-yield issuance reached $302 billion.

Investment-Grade (BBB- and above):

• Historical annual default rate: 0.10%
• AAA/AA defaults (31-year average): 0.0% and 0.2%
• BBB defaults: approximately 0.3% annually
• Typical spread over Treasuries: 80-150 bps
• Current yield: 5.3-6.0%

High-Yield (BB+ and below):

• Historical annual default rate: 4.22%
• B-rated default rate: approximately 7% annually
• CCC/C default rate: 26.6% annually
• Typical spread over Treasuries: 300-500 bps
• Current yield: 7.0-8.5%

The math on credit risk:

For a typical BBB-rated bond:

• Annual default probability: ~0.3%
• Recovery rate if default occurs: ~40% of face value
• Expected annual loss: 0.3% x 60% = 0.18% (18 bps)

Yet BBB spreads are typically 100-150 bps. The difference (approximately 80-130 bps) represents liquidity premium and risk appetite compensation, not expected default losses.

The durable lesson: Most of the corporate spread isn't paying for defaults. It's paying for the illiquidity of corporate bonds versus Treasuries and for the possibility (however remote) of a severe credit event. Research confirms that structural factors like supply and liquidity explain only 25% of spread changes, with the remainder driven by a common risk appetite factor (Collin-Dufresne, Goldstein & Martin, 2001).

The Risk-Return Tradeoff (Quantified)

Here's what each step up in credit risk actually costs and pays:

What the table reveals:

1. Agencies are almost free yield: 60 bps extra for near-zero incremental risk
2. IG corporates offer excess compensation: 110 bps spread for only 6 bps of expected loss means 104 bps of "extra" compensation (liquidity + risk premium)
3. High-yield is a different game: 300 bps spread for 250 bps of expected loss leaves only 50 bps excess (and that assumes normal default years)

The practical point: Moving from Treasuries to investment-grade corporates has historically been one of the best risk-adjusted trades in fixed income. Moving from IG to high-yield requires believing you can avoid the defaults.

Spread Mechanics (Where the Extra Yield Comes From)

That 100-150 bps spread on investment-grade corporates over Treasuries breaks down into three components:

1. Default Premium (~20-30 bps for IG)

This is compensation for the probability of actual loss. For investment-grade, it's a small portion of total spread because defaults are rare. Structural models of default explain only 20-30% of observed IG spreads; the remainder represents non-default compensation (Huang & Huang, 2012).

2. Liquidity Premium (~20-40 bps)

Corporate bonds trade less frequently than Treasuries. Bid-ask spreads are wider. If you need to sell before maturity, you'll pay a transaction cost. The market compensates you upfront for this friction.

Normal conditions: IG bid-ask spreads of 0.20-0.30% Stressed conditions (March 2020): Bid-ask spreads widened to 1.0%+

Liquidity premia were near zero in early 2007 and exploded precisely when selling became urgent, demonstrating that liquidity risk is procyclical (Dick-Nielsen, Feldhutter & Lando, 2012).

3. Risk Appetite Premium (~50-80 bps)

This residual reflects investors' general willingness to hold risky assets. When fear spikes (VIX above 25), this component expands even if fundamentals haven't changed.

The practical implication: When spreads widen, ask yourself which component moved. If corporates sell off purely because of risk appetite (VIX spike, no fundamental deterioration), that's often an opportunity, not a warning.

Detection Signals (How to Monitor Each Segment)

Track these metrics to understand what's happening in each market:

For Treasuries:

• Federal Reserve policy (the dominant driver)
• Inflation expectations (TIPS breakevens)
• Treasury auction demand (bid-to-cover ratios)

For Agencies:

• Mortgage rate movements (affects prepayment speeds)
• Fed MBS holdings (quantitative tightening reduces demand)
• Spread to Treasuries (widening signals reduced risk appetite)

For Corporates:

• ICE BofA Option-Adjusted Spread (OAS) indices on FRED
• High-yield default rates (Moody's, S&P monthly reports)
• VIX level (above 25 typically means elevated spread volatility)

Common Mistakes (And What They Cost)

Mistake 1: Treating All Yield as Equal

The error: Comparing a 7.5% high-yield fund to a 5.5% investment-grade fund and concluding the HY fund is "better."

The cost: In a recession year with 6% HY defaults and 40% recovery, you lose approximately 3.6% of principal to defaults, wiping out most of your yield advantage.

The fix: Compare yield minus expected loss. IG at 5.5% with 0.1% expected loss = 5.4% net. HY at 7.5% with 2.5% expected loss = 5.0% net. The "premium" often disappears on a risk-adjusted basis.

Mistake 2: Ignoring Liquidity in Stress

The error: Buying illiquid corporate bonds because they offer 50 bps extra yield, then needing to sell during a crisis.

The cost: March 2020 showed IG bid-ask spreads widening to 100+ bps. Selling a $100,000 position cost $1,000+ in transaction costs alone.

The fix: Hold illiquid bonds only in accounts where you genuinely won't need liquidity. Match bond liquidity to your liquidity needs.

Mistake 3: Chasing Spread When Spreads Are Tight

The error: In late 2024, IG spreads hit 79 bps (tightest since 2005). Investors continued buying corporate credit at minimal premium over Treasuries.

The cost: When spreads eventually normalize to 120+ bps, prices fall. A 50 bps spread widening on a 7-year duration bond means approximately 3.5% price decline.

The fix: Track spread percentiles. If spreads are in the bottom 10% of historical range, you're being paid historically little for credit risk. Consider Treasuries or agencies until spreads normalize.

Implementation Checklist (Tiered by Experience)

Essential (every fixed-income investor)

• Understand the three segments and their risk profiles before buying any bond fund
• Know your portfolio's allocation across Treasury/agency/corporate
• Check the current spread environment (is IG spread above or below 100 bps?)
• Match bond segment to your risk tolerance and liquidity needs

High-Impact (building a bond allocation)

• Use Treasuries or agencies as your core safety allocation
• Limit investment-grade corporate exposure to what you can hold through stress
• Avoid high-yield unless you have a specific income need and can tolerate volatility
• Rebalance when spreads reach historical extremes (tight or wide)

Optional (for active managers)

• Monitor spread components separately (default, liquidity, risk appetite)
• Track sector spreads within investment-grade (financials vs. industrials vs. utilities)
• Use CDS indices as a pure credit signal separate from bond liquidity effects

Next Step (Put This Into Practice)

Check your current bond allocation and calculate your credit risk exposure.

How to do it:

1. List your bond holdings (funds or individual bonds)
2. For each, identify: Treasury, agency, IG corporate, or HY corporate
3. Calculate the weighted average yield and weighted average credit quality
4. Compare your spread exposure to current market levels

Interpretation:

• If you're 100% Treasuries: You have zero credit risk but may be leaving 50-100 bps of yield on the table
• If you're 50%+ high-yield: You have significant credit risk that will hurt in a recession
• If your average spread is below historical median: Consider whether you're being fairly compensated

Action: For most investors, a blend of Treasuries (safety), agencies (yield pickup with minimal risk), and investment-grade corporates (modest credit exposure) provides the best risk-adjusted outcome. High-yield should be a tactical allocation, not a core holding.