Investing in government bonds is perhaps the most common avenue for portfolio diversifications and steady income. A huge field for bonds is split into two major parts; corporate and government bonds.But what are government bonds? What is the difference from corporate bonds? The article seeks to analyze these major differences and the pros and cons, giving investors a good guideline on which one fits better to their needs.
What Are Government Bonds?
Government bonds refer to debt securities issued by a national government to finance public spending. Such bonds are considered risk-free since they are backed by the taxing power of the government, generating revenue from the citizens. In the U.S., Treasury bonds (T-bonds), Treasury notes (T-notes), and Treasury bills (T-bills) are considered government bonds. Other countries too have such instruments, such as UK Gilts and the Indian Government Securities (G-Secs).
What Is a Company Bond?
A company bond, also called corporate bond, is a debt security issued by a corporation in order to raise money for business operation, expansion, or refinancing of existing debt. Corporate bonds usually pay higher yields than government bonds as a compensation to the investors for the additional risk involved in lending to a company rather than an entire government.
Key Differences Between Corporate Bonds and Government Bonds
Even though they refer to fixed-income instruments, corporate bonds and government bonds offer several key differences:
1. Risk-Free Security
On the risk scale, government bonds are seen to be safe considering that the government collects taxes.
On the other hand, corporate bonds are higher in risk. In fact, small or less creditworthy companies have a higher risk of default. In case the company runs into financial crisis, it might return only a part of the entire investment.
2. Interest Rates (Yield)
A comparison of the yield on corporate bonds and that of government bonds will reveal that corporate bonds are inarguably higher. This is because it’s always a norm that risk premium is often assigned or charged by shareholders each time they lend their money to any corporation rather than that of a sovereign country.
Compared to Corporate Bonds, Government Bonds have lower yields but greater safety, so one will like them during periods of economic uncertainty.
3. Tax Considerations
Tax exemption or lower tax rates exist in certain countries for interest income of government bonds. This entails even more benefits for investors.
Corporate bonds’ interest yields are subject to regular income taxes and usually reduce the overall return.
4. Liquidity
In general, government bonds have a higher liquidity because these bonds are traded widely in the financial markets, and they have generally sovereign backing.
For corporate bonds, they also possess little liquidity, with particular dominance of those small issued companies, agglomerating these securities at the cash bunkers, and making it tough for investors to sell them quickly at a lucrative price.
5. Duration and Maturity
In general, government bonds have a term of maturity longer than that, usually ranging from short term (one year or less) to long term (30 years or more).
Corporate bonds maturities are mostly shorter, but available for long-run investments by established companies.
Which Is Better?
It depends on the financial objectives, risk appetite, and investment horizon of an investor.
For Conservative Investors: Government bonds are better for their safety and reliability. They work well for retirees, those who are risk averse, and those who want to achieve stability.
For Income-Focused Investors: Moderate risk should be taken by such investors interested in corporate bonds which usually offer the greatest yield and hence higher income.
For Diversification: Equal investment in corporate as well as government bonds will help balance out the risk-return equation to build a better safe and all-rounded portfolio.
Conclusion
Government bonds and corporate bonds both fulfill a critical function in investment portfolios. The best practice is to understand their differences and evaluate an individual’s tolerance to risk before an informed decision can be made as to which type of bond might be more advisable for an investment portfolio.
