Corporate and government bonds are essential to investigate as part of an investor’s portfolio diversification and defensive strategy. Understanding both can help you make an informed decision about where to invest your money and being aware of their benefits and risks as well as their similarities and differences empowers you as an investor.
What is a corporate bond?
Sometimes companies need a lot more money than banks can lend them and one way in which companies may raise high amounts of money to finance their growth and projects is to issue corporate bonds. They do this through a process called ‘bond issuance’, for example, a company issues $100 million at 6 per cent and each bond has a face value of $10,000. These bonds would then be offered to investors to raise the $100 million that the company needs to fund their venture. Corporate bonds vary in terms and creditworthiness, so you must understand the issuer’s creditworthiness and read their prospectus and/or annual report.
What is a government bond?
A Government bond is a way in which a country’s government raises money to build infrastructure or support its development by issuing debt securities (financial assets that can be traded) and selling them to investors in much the same way corporations issuing bonds. There are two types of government bonds issued by the Australian Government: Treasury Bonds (TBs) and Treasury Indexed Bonds (TIBs). TBs have a fixed rate, and TIBs have an indexed rate linked to the “Consumer Price Index” (CPI). Both are issued in a series, each with its own coupon rate and maturity ranging from less than one year to over 25 years.
How are bonds rated?
Issuers of bonds are rated by professional rating agencies like Standard & Poor’s and Moody’s based on their creditworthiness or their ability to repay a debt.
For example, the Australian Government has a rating of AAA, meaning that their bonds are almost risk-free as the probability of the Australian government defaulting is minimal. Companies are also rated by rating agencies. The lower the rating, the higher the risk for the investor.
Types of interest rate for government and corporate bonds
There are three main types of interest paid from bonds: fixed rate, indexed rate and floating rate as described below:
- Fixed rate: It is a stable rate across the life of a loan until maturity.
- Indexed rate (linked to CPI): The coupon rate is indexed against the CPI, thus protecting you against inflation.
- Floating rate: This rate can fluctuate during the term of the bond. This coupon rate is based on an underlying interest rate plus a percentage. For example (BBSW plus 2 per cent).
Table 1. Types of interest rate in government vs corporate bonds
|Type of interest rate||Government Bonds||Corporate Bonds|
|Fixed rate||Treasury Bonds||Available|
|Indexed rate- linked to CPI||Treasury Indexed Bonds||Available|
|Floating rate||Not available||Available|
Investing in bonds has the following benefits:
- Security: The bond issuer agrees and is contractually obligated to pay your initial investment back to you upon maturity.
- Regular income: Bonds are a way to create a predictable source of income. This can be useful if for example you are near retirement or if you want to know how much money you will be receiving in the future for your investment. At the Australian Bond Exchange (ABE), we can create portfolios that pay you on a regular schedule throughout the year.
- Diversification: Government and corporate bonds are part of an investment portfolio’s defensive assets. They are the assets that provide income stability and compensate for the risk of incurring losses due to investing in higher-risk growth investments, generally in certain shares. In an investment portfolio, it is essential to diversify the assets you hold. For example, if you invest most of your money in shares in one industry; when that industry does not do well for any reason, the value of your shares and your overall portfolio will decline. Therefore, you could try having shares of different companies and industries; so, when one sector does not do well, you can still have earnings from shares that are performing well. However, holding only shares is risky. Therefore, it would be better to have in your portfolio defensive assets too, such as government or corporate bonds. Although these types of assets have lower returns, they also have lower risks. Suppose there were to be a recession or global financial crisis. In that case, you could preserve your capital by investing at least your age as a percentage in bonds.
- Liquidity: You can sell your bonds before maturity and convert them to cash. At ABE, we offer a market so that your bonds have liquidity.
What are the risks of investing in bonds?
- Interest rate risk: Interest rate risk is the risk that interest rates increase, making the price of a fixed rate bond fall. Conversely, if interest rates decrease, the price of a fixed-rate bond rises. It is also known as duration risk because the concept is linked to the bond’s term. Longer-dated bonds are more sensitive to rate changes than shorter-dated bonds. However, fluctuating rates will not impact you if you hold the bond until maturity.
- Credit risk: Credit risk is when investors’ initial payment and interest are not paid in time. The way to minimise this risk is by reviewing the credit rating of the government or company and making an informed decision that suits your personal situation and needs.
- Default risk: Default risk is he risk that the issuer goes into liquidation and is unable to repay the bond. The default risk is higher for corporate bonds than government bonds (in most cases),
- Liquidity risk: Liquidity risk is the risk of not being able to sell your bond quickly when needed. However, at ABE, we offer a market so that you can sell your bond before maturity if you need to.
Corporate vs government bonds
Corporate and government bonds are similar in that they are both loans to an issuer with fixed maturity dates and coupons paid at regular intervals; they are both defensive assets. However, corporate bonds have higher yields because they reflect the higher risk incurred by investors in lending money to companies. Typically, in terms of bond rates, government bonds can have a fixed bond rate or one indexed to inflation. On the other hand, corporate bonds can have a fixed rate, floating-rate or inflation-linked rate. Regarding default risk, it is usually higher for corporate bonds than for government bonds.
In terms of time to maturity, there are some differences between corporate bonds and government bonds. The maturity times for corporate bonds generally vary between three to seven years, with a few 10-year bonds available. Government bonds can have maturity dates of up to thirty years or longer. It is important to note that longer maturity bonds have higher risks than shorter-maturity bonds. Because if interest rates increase, the price of your bond decreases; and with a longer term there is a higher probability the issuer may go into liquidation. On the other hand, if interest rates decline, prices increase.
Table 2. Similarities and differences between government bonds and corporate bonds.
|Characteristic||Government Bonds||Corporate bonds|
|Type of asset||Fixed income||Fixed income|
|Type of investment||Defensive||Defensive|
|Type of loan||Loan to an issuer with fixed maturity dates||Loan to an issuer with fixed maturity dates|
|Coupons||Coupons are paid at regular intervals||Coupons are paid at regular intervals|
|Risk of default||Lower risk of default as they are backed by a government||Higher risk of default|
|Yields||Lower yields||Higher yields that reflect higher risk incurred by investors|
|Type of interest rate||Fixed rate interest or interest rate indexed to inflation||Fixed rate, floating-rate or inflation-linked interest rates|
Where can you buy corporate and government bonds?
Most corporate and government bonds are traded “Over the Counter” OTC. The government bond market is larger than the corporate bond market. State governments also issue bonds.
You can buy corporate bonds at the ABE with an initial investment of $10,000 AUD.
Consumer Price Index (CPI): It is the measure of the average change over time in the price that households pay for a basket of goods and services.
Face Value: It is the initial investment in a bond, and the amount of money that will be returned to you when the bond matures.
Financial asset: A financial asset is a non-physical, asset that represents a claim of ownership to cash or future payments. Some examples of financial assets are stocks, bonds, cash, and bank deposits.
Financial Instrument: An asset that can be traded.
Interest: Interest is charging money in exchange for lending money.
Maturity: The term when your loan to the company ends and when the company pays back your initial investment.
Yield: Yield is the annual return on a bond.
Yield to Maturity (YTM): YTM is a common way to measure yield. This is the total return an investor will receive by holding the bond until it matures, and it includes all interest paid from buying the bond until the bond matures. The bond yield moves in an inverse direction to its price; when the bond’s price increases, yield decreases.
Disclaimer: This document is for educational purposes only. The information and any advice provided in this article has been prepared without considering your objectives, financial situation or needs. Because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to those things.
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