Bond interest rates in the market, usually referred to as yields, vary based on many factors. Typically, shorter-term bonds carry lower interest rates than longer-term ones. Credit risk also factors into the equation. Although both AA- and AAA-rated bonds qualify as "investment-grade" and are relatively safe, the AAA bond, which holds the highest possible rating, will typically carry the lower rate of interest.
A corporate bond is an investment by which you lend money to a company based on its promise to repay you with interest. Generally, lower-rated corporate bonds, which are issued by companies with weaker credit, trade for higher yields than higher-rated bonds, compensating investors for the risk of buying a bond with a greater risk of default. For instance, as of mid-September 2013, a five-year AAA-rated corporate bond traded for a 1.88 percent yield, while a five-year AA-rated bond had a 2.14 percent yield. The spreads between the two bonds can vary over time, and there are even cases where AA bonds can trade for lower rates. Usually, this occurs when investors are worried about interest rates going up. In these instances, the chance that AA bonds will get called sooner than a AAA bonds can make it more valuable.
Municipal bonds are issued by local governments like cities, states, counties or local agencies. They typically carry lower interest rates than other bonds because you're usually able to collect the interest without having to pay taxes on it. A five-year AAA-rated municipal bond traded at a 1.44 percent in September 2013, also lower than the AA bonds's 1.79 percent. Longer-term bonds had the same relationship -- 4.03 percent for a 20-year AAA bond and 4.33 percent for a 20-year AA bond. The A bond had an even higher yield of 4.84 percent.
Sovereign bonds, which are bonds issued by foreign governments, tend to be variable for reasons above and beyond their credit ratings. For instance, according to research reported in ING's "Global Perspectives," when U.S. 10-year bonds were returning 2.6 percent, Canada's were returning 2.5 percent, the UK's returned 2.7 percent and Australia's returned 3.8 percent. All four countries, though, enjoy the same AAA rating. At the same time, New Zealand's AA bonds traded at a higher 4.7 percent yield than Poland's A-rated 4.6 percent bonds.
Ratings and Default Risks
The yield differences between AA and AAA bonds are relatively slim because the risk differentials are minimal. From the period of 1970 through 2006, no municipal bonds rated AAA by Moody's defaulted. Only 0.06 percent of AA-rated municipal bonds defaulted. In the Standard and Poors rating system, both categories had no defaults. In corporate bonds, both AA- and AAA-rated bonds under Moody's system had a 0.52 percent default rate. S&P AAA corporate bonds had a 0.6 percent default rate as opposed to a 1.5 percent default rate for AA bonds.
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.