Risk and return

In business school, one of the fundamental lessons is that the greater the risk you undertake, the higher the return you should anticipate. Government-issued bills, notes, and bonds represent essentially sovereign risk and are typically regarded as the safest instruments in the market, consequently offering the lowest interest rates.

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Slightly riskier are the debts issued by blue-chip companies, which yield a marginally higher interest rate, followed by the borrowings of lower-tier or higher-risk companies that offer a more substantial interest rate.

What drives this risk-return relationship? Fundamentally, weaker companies carry a greater risk of default on timely interest payments or even principal repayment upon maturity. To attract investors to these lower-quality debt instruments, issuers are compelled to offer a higher rate of return, compensating investors for the increased risk they assume. This, of course, assumes that these companies still operate with manageable risk under normal circumstances.