Government bonds and corporate bonds differ significantly in terms of the potential risk for default. Government bonds carry varying degrees of risk depending on the country issuing them. For example, U.S. government bonds are considered less risky compared to bonds issued by countries with a higher likelihood of default. During Greece’s financial crisis, their 10-year bond yields skyrocketed to around 36.591% due to genuine concerns about default. The high yield was necessary to compensate for the increased risk associated with those bonds.
Although the situation in Greece has improved, the risk of default is still higher than in the United States. As a result, Greek bonds continue to offer a higher yield, currently around 4.132%, in contrast to the lower yield of 2.886% on 10-year U.S. Treasury notes. The extremely low risk of default in the U.S. contributes to the lower yield.
Efforts are made to prevent government bond defaults, as seen in the case of Greece. Governments have more flexibility to intervene and support their bonds if needed. However, with corporate bonds, if a company goes under, bondholders may face losses. Bondholders are typically prioritized over shareholders when it comes to receiving payment, but there is still a risk that bondholders may not recoup their full principal and interest.
The yield on corporate bonds includes a risk premium, reflecting the added risk associated with investing in corporate debt. Bonds issued by companies with lower risk are associated with a smaller risk premium, while riskier corporate bonds require a higher risk premium.
It is important to note that not all government bonds are considered less risky than corporate bonds. Some corporate bonds may be perceived as lower risk compared to certain government bonds. For example, the yield on a 10-year Indian government bond may be over 7%, while high-quality corporate bonds with a similar duration may offer an average yield of around half that amount. The relative risk and risk premiums of bonds vary depending on the specific issuer and market conditions.
Managing Governments vs. Corporations
Government bonds generally tend to be safer than corporate bonds and typically offer lower yields compared to even the safest corporate bonds. Economic challenges can often be managed better by governments than by corporations, as governments have greater flexibility to take on long-term debt.
Governments, even the most stable ones like the United States, continuously accumulate debt with relatively little immediate concern. However, excessive levels of government borrowing are ultimately unsustainable. If a country’s debt reaches a point where the interest becomes unmanageable, it can lead to higher interest rates and potential issues. While the horizon for such concerns is usually distant, it’s important to monitor these factors, even for long-term bonds.
Governments have options to tackle impending crises, such as inflationary measures that can devalue their existing debt. However, these measures can have significant consequences and are generally considered undesirable. Some countries may be closer to a crisis than others, but bondholders should pay attention to assess the potential risks.
Corporate bond risks depend on both macroeconomic and microeconomic factors. Companies need to maintain a favorable business environment and sustain their competitive advantage to ensure continued profitability throughout the bond’s term. Default risk for corporate bonds extends beyond the survival of the company; it also includes the ability to meet interest payments.
Timely interest payments are crucial for bond issuers. A default occurs when they fail to make these payments, similar to someone defaulting on a loan. Governments and corporations prioritize avoiding bond defaults and make efforts to prevent them.
Corporations, however, have more limited means to manage default risks compared to governments. Governments can often borrow more to meet their obligations, which is a primary strategy for managing their debt. Corporations, on the other hand, cannot rely on unlimited borrowing. Reducing debt and avoiding negative financial indicators are important for maintaining investor confidence, as investors are hesitant to lend to struggling companies.
While governments and corporations share a commitment to prevent bond defaults, the means available to governments are generally more extensive, whereas corporations face greater limitations in managing default risks.
Diversification to the Rescue
Diversification has become a prominent strategy in investment funds, particularly mutual funds, where bond funds now hold a wide range of different bonds to spread the risk. Bond index funds function similarly to stock index funds, holding all the components of an index, and some funds even combine a large basket of stocks with a large basket of bonds, maximizing diversification.
Diversifying bonds involves combining government and corporate bonds, as well as including bonds of lower quality. This allows investors to access a broader range of bonds they may not consider individually. The goal is to limit the risk associated with lower quality but higher yielding bonds by mixing bonds of various qualities. If some bonds default, the impact will be less significant compared to investing solely in risky bonds.
Unlike stocks, diversification is not the only or best way to manage risk within the bond asset class. Investing in so-called risk-free bonds can provide maximum risk management. However, diversification in bonds allows investors to expand their expected returns while managing the downside risk.
The trade-off between risk and return exists, and including lower quality bonds increases the portfolio’s return while simultaneously managing the risk associated with these additions.
While diversification of stocks has limited value due to systemic risk, bond risk is less influenced by systemic factors. Systemic risk in bonds is related to significant economic changes that can be more easily anticipated. In contrast, a bear market in the stock market can occur due to shifts in investor preferences.
Managing systemic risk in bonds can be achieved by adjusting bond portfolios to include virtually risk-free bonds, such as U.S. treasuries, if necessary. Therefore, diversification plays a crucial role in managing risk effectively with bonds, while diversifying holdings with other assets is more crucial for managing risk in stocks. Bonds provide additional diversity that can be utilized to diversify both bond holdings and other investments.
How Much Should We Rely on Corporate Bonds?
Diversification should not be pursued blindly, as each addition to a portfolio must be justified in terms of its risk-to-return ratio. While the bond market generally prices bonds appropriately, it is important to focus on risk management within bond portfolios and avoid excessive risk.
Unlike stocks, where fundamental analysis has limited usefulness due to the influence of supply and demand on prices, fundamental analysis is crucial in bond selection. The health of government bonds depends on the financial stability of governments, while corporate bonds are closely tied to the health of the issuing companies over the bond’s duration.
| Benefits of Bonds | Characteristics of Bonds |
| Risks of Bonds | Bonds as Investments |
| Bonds for Diversification | Bonds vs. Stocks |
| Corporate vs. Government Bonds | Trading Bonds |
| Bonds and Liquidity | Bond Funds |
Government bonds should be evaluated to ensure governments are not overleveraged, as seen with the Greek situation. Corporate bonds require careful consideration of the company’s expected health throughout the bond’s life. Speculation and unknown factors play a greater role in corporate bonds compared to government bonds.
Investors must exercise caution with corporate and certain government bonds, and the level of risk tolerance will determine the appropriate amount of risk to take on with bonds. A blanket approach of owning thousands of bonds across indexes may not be the most suitable strategy. While it may be efficient, it is challenging for individual investors to assess the value and risks of specific bonds.
For those who prioritize safety and hold significant portions of their portfolios in bonds, risk management should be a priority. Choosing quality government bonds over diversification is generally preferred. A heavier weighting towards quality government bonds and a lesser focus on corporate bonds can help manage risk. Adding riskier bonds to the portfolio for the sake of diversification increases risk rather than managing it.
The key is to strike the right balance between risk and return with bonds. This may involve investing in both government and corporate bonds to pursue better returns while remaining comfortable with the additional risk.
