Chapter 7: Credit risk: corporates, munis, and junk
Every bond in this guide so far had the same borrower: the US Treasury, the one name the market treats as worry-free. Step past that shelf and the store changes. In June 2026 a 13-week Treasury bill pays 3.73% (June 8, 2026 auction), and somebody out there will happily offer you more for the same stretch of time: a utility, a hospital chain, a school district, a casino company three payments behind on its own suppliers. They offer more because they have to. You are now carrying a risk the Treasury never handed you, the chance that the borrower simply does not pay you back, and the extra yield is your wage for carrying it.
That extra yield has a name. The credit spread is the gap between what a borrower pays and what the Treasury pays for the same term, and the honest way to read it is as a price tag on worry. The more the market doubts a borrower, the wider the spread gets. This chapter walks the three aisles where that price tag hangs: corporate bonds, municipal bonds, and the shelf the brochures call high yield while everyone else calls it junk. On the way out, Hugo brings in a brokered CD pitch, and we decode it line by line.
What does a credit rating actually tell you?
A credit rating is a letter grade on a borrower's ability to pay you back, published by agencies whose whole business is reading balance sheets. The grade is an opinion about the odds of default, scored on a scale that runs from "sleep fine" to "check the news daily". It is an opinion with a good track record in aggregate and a spotty one in famous individual cases, and the agencies sometimes revise it after the bad news instead of before. Use a rating to learn which aisle a bond lives in. Never read it as a promise that nothing can go wrong, because the borrowers that blew up most spectacularly in market history were carrying respectable letters shortly beforehand.
The whole scale fits in one table, and the line worth memorizing is the one between BBB and BB, because the entire bond market splits its vocabulary, its buyers, and its behavior at that line.
| Grade band | Letters (S&P style) | Plain English |
|---|---|---|
| Highest quality | AAA, AA | Default would shock the market |
| Solid | A | Strong payers carrying ordinary business risk |
| Lower investment grade | BBB | Fine today, worth watching in a recession |
| Speculative | BB, B | Real default risk in bad years |
| Deep junk | CCC and below | Trouble is expected, frequent, and priced in |
Bonds rated BBB or better are investment grade, the club that pension funds and conservative mandates stay inside. Everything below is high yield, which is the polite label, or junk, which is the honest one. Both names describe the same shelf, and the polite name was invented by the people selling it.
A yield is two prices stacked
The cleanest way to read any non-Treasury yield is as two stacked pieces: the Treasury rate for that term, which is the price of time, plus the credit spread for that borrower, which is the price of doubt. A solid company might pay a modest spread in a calm year. Let fear into the room and the spread widens fast, and a widening spread pushes the bond's price down through exactly the seesaw mechanics of Chapter 2, like a second rider climbing onto the plank.
The timing of that widening matters more than most buyers ever notice. Spreads blow out in precisely the kind of markets where stocks are falling too, because both prices are reacting to the same recession worry. Corporate bonds therefore do their worst work in the same weeks your stock funds do theirs, which weakens the cushioning job you probably bought them for. The worry-free Treasury has no spread to widen, and that is the quiet reason it steadies a portfolio in a panic better than anything that pays more.
Munis: the aisle with a tax discount
A municipal bond, a muni for short, is a loan to a state, a city, a school district, or a toll road. Its sticker yields look unimpressive next to corporates, and the sticker is misleading by design: muni interest is generally free of federal income tax, and when the bond comes from your own state it is usually free of state income tax as well. A muni pays you in two currencies at once, interest and tax relief, so comparing it with anything taxable means converting both sides into the only currency that matters, which is what you keep.
The conversion tool is the tax-equivalent yield: take the muni's yield and divide it by 1 minus your marginal tax rate. Run it once with real inputs. A saver who loses 33.3 cents of each extra interest dollar (a 24% federal bracket plus a 9.3% state rate) holds a 3.00% in-state muni. Dividing 3.00 by 0.667 gives about 4.50%, so a fully taxable account would need to pay about 4.50% before this saver kept the same money. Nothing on the June 2026 T-bill board comes close to that figure, which is exactly why high earners in high-tax states keep hearing about munis at dinner parties.
The three-way race, settled by the calculator
The fair race is a savings account against a T-bill against an in-state muni, with each runner taxed by its own rules. Savings interest loses federal and state tax. T-bill interest loses federal tax only, thanks to the state exemption Chapter 3 introduced. The in-state muni keeps everything. The calculator below runs the race for your bracket and your state; its defaults are dated June 2026, and the assumptions are stated inside the widget.
At the defaults, a 24% federal bracket and a 9.3% state rate, the podium reads like this: a 4.10% APY savings account (top online accounts pay roughly 4.0 to 4.25% APY, aggregator data, June 2026) keeps 2.73%, a 3.73% T-bill (June 8, 2026 auction) keeps 2.83%, and a 3.00% in-state muni keeps the full 3.00%. The in-state muni wins this setup. Now change the setup and watch the podium reshuffle, because nothing about that result is permanent. Drop into a lower federal bracket, or move to a state with no income tax, and the muni's only advantage shrinks while its low sticker yield stays put; the T-bill or even the savings account takes the lead. The honest summary is that this shelf has no standing champion, only a winner for your bracket, your state, and this month's rates, which is why the calculator exists instead of a slogan. High earners should also know about the 3.8% net investment income tax that applies above $200,000 single or $250,000 joint (IRS); brackets, NIIT, and the deeper muni rules belong to the Finvest Tax Playbook.
Junk: the shelf with the red label
Junk bonds offer equity-like drawdowns with bond-like upside, and that trade is lopsided in the seller's favor. Your best case is capped: collect the coupons, get your principal back, done. Your worst case looks like a stock's worst case, because the same recession that crushes a shaky company's shares also threatens its ability to pay its debts, so junk prices fall alongside stocks in exactly the years you want your bonds standing firm. Anyone who wants stock-shaped risk can buy stocks, which at least carry stock-shaped upside.
None of that makes junk unbuyable. Professional investors hold it in measured slices, with eyes open, paid by the spread to do so. The trouble starts when junk arrives in disguise. A product marketed as a "high yield cash alternative" that pays meaningfully more than a 3.73% T-bill (June 8, 2026 auction) is paying you out of some risk it has taken on, whether the brochure names the risk or never mentions it. The market does not hand out extra yield for free, so when the extra appears, your only job is to find what is being charged for it.
Hugo's brokered CD, decoded
Hugo, 52, a dentist with $1.4M saved, sat through a pitch for a brokered CD, which is a bank certificate of deposit bought through a brokerage account instead of directly from a bank. The FDIC insurance behind it is real, the same $250,000 per depositor, per bank, per ownership category that Chapter 1 covered. The differences live in the plumbing. A brokered CD is bought and sold at a price, like a bond, and a sales markup can sit inside that price where no statement line will ever itemize it. And there is usually no early-withdrawal penalty schedule, because there is no early withdrawal at all: needing your money before maturity means selling the CD at whatever the market offers that day, which after a rise in rates can be less than you paid. The seesaw from Chapter 2 applies to anything that trades at a price, and a brokered CD trades at a price.
Hugo ran the pitch through the seller's-pitch test, which is just three questions asked before the promises get repeated. What do you and your firm earn on this trade, where does that compensation sit, and what exact price do I get if I need out early? The answers came back soft: the markup lived inside the offer price, the early exit was "whatever the market is then", and the headline rate, 4.05% on the pitch sheet (the seller's illustration, no date attached), was quoted with no mention of taxes. Hugo did the after-tax arithmetic from the calculator above at the same 24% federal and 9.3% state setup: CD interest is taxed by both, so the pitched 4.05% would keep about 2.70%, while the plain 3.73% T-bill (June 8, 2026 auction), taxed federally only, keeps 2.83% with no markup, no exit haircut, and no pitch meeting. He passed, politely.
Take credit risk on purpose, in doses you sized yourself, or do not take it at all. Never absorb it by accident inside something marketed as a cash alternative, because the extra yield always has a job, and the job is paying you for a risk somebody preferred not to name.
Where people go wrong
- Reaching for the "high yield cash alternative." Anything that beats the T-bill is charging you for a risk. The brochure's silence about which risk is information in itself.
- Assuming the muni always wins. It won the calculator's default setup at 24% federal and 9.3% state, June 2026 rates. Change the bracket, the state, or the month, and the podium reorders. Run your own numbers before copying a coworker's.
- Treating ratings as guarantees. A rating is a graded opinion that gets revised, sometimes late. It tells you which aisle you are in, never that the aisle is safe.
- Buying junk as ballast. Ballast has one job, holding steady while stocks fall, and junk sinks in the same storms. Sized, deliberate junk is a choice; junk inside the safe sleeve is a mistake.
- Signing for a brokered CD without pricing the exit. Ask for the markup and the resale mechanics before the FDIC logo does the talking.
Key takeaways
- Every non-Treasury yield is the Treasury rate plus a credit spread, and the spread is the price tag on worry: it widens in scared markets, when stocks are falling too.
- The rating scale splits at BBB. At or above is investment grade; below is high yield, honestly called junk: equity-like drawdowns, bond-like capped upside.
- Munis pay in interest plus tax relief. At the calculator's June 2026 defaults (24% federal, 9.3% state), savings at 4.10% APY keeps 2.73%, a 3.73% T-bill keeps 2.83%, and a 3.00% in-state muni keeps 3.00%: the muni wins that setup, and only that setup.
- Brokered CDs carry real FDIC insurance plus a markup in the price and an exit at market value only. Run the seller's-pitch test before the logo.
- Take credit risk on purpose, sized, or not at all, and never by accident inside a "cash alternative".
Sources: TreasuryDirect auction results · TreasuryDirect tax treatment · IRS Topic 403, interest income · IRS net investment income tax · FDIC deposit insurance FAQ · CFPB on CDs · savings APY band from aggregator data, June 2026 · Finvest Tax Playbook