Understanding the Risk Profile of Corporate Bonds vs Government Bonds
When it comes to fixed-income investments, corporate bonds and government bonds are two of the most commonly discussed options. Both serve as secure means of earning income, but they differ significantly in terms of risk. This article aims to elucidate why corporate bonds are generally not considered as inherently riskier as government bonds, as well as the specific factors and nuances that can affect the risk profile of each type of bond.
Comparing Risk Profiles
One of the most significant differences between corporate bonds and government bonds lies in the underlying guarantor. Government bonds are backed by the financial strength and credit of the issuing government. The US, for instance, is considered one of the least risky borrowers in the world because lenders believe the US government will continue to levy taxes and manage its revenues to make future payments. On the other hand, corporate bonds are subject to the credit risk of the company issuing them. For example, the Ford Motor Company, while better regarded than the average company, is still not as well-regarded as the US government.
Country-Specific Factors
The risk profile of government and corporate bonds can also vary by country. For example, a government bond from Zimbabwe might be riskier than a bond from a highly rated company like Microsoft, which is based in the United States. This difference primarily arises from the creditworthiness of the issuing government. Zimbabwe, given its economic instability and high inflation, presents higher default risk for its bonds.
Foreign Currency and Exchange Risks
In addition to credit risk, holding foreign government bonds can also expose investors to foreign exchange risks. This is particularly relevant for investors who are considering bonds from countries with currencies that are volatile or have high inflation rates. For example, an investor holding Argentine government bonds might face losses if the Argentine peso weakens against the US dollar. Conversely, an investor in US Treasury bonds might benefit from a stronger dollar, which can increase the value of their investment in terms of their home currency.
Credit Ratings and Factors Affecting Value
Credit ratings play a crucial role in evaluating the risk of both corporate and government bonds. Corporate bonds are typically rated across various tiers, ranging from the highest, AAA, which is considered better than most governments, to non-investment grade or even outright default. An individual corporate bond's credit rating is just one factor to consider. Other aspects that can affect its value include:
Callable Features: Bonds that can be called back by the issuer before their maturity can impact the bondholder's returns and cash flow. Fixed vs Variable Interest Rates: While fixed-rate bonds provide a fixed income stream, variable-rate bonds can expose bondholders to interest rate volatility. Death Puts: These are put options often included in certain bond contracts, allowing the bondholders to sell the bond back to the issuer if the bondholder dies.Government bonds, too, vary significantly in terms of their credit ratings. While many modern democracies, such as the United States and Germany, maintain AAA or near-AAA credit ratings, other countries may struggle with financial troubles. For instance, many Russian bonds are currently at a lower credit rating due to economic sanctions and geopolitical tensions. This variability highlights the importance of thoroughly researching and considering the creditworthiness of the issuer before investing in any bond.
Conclusion
In summary, corporate bonds are generally not considered as inherently riskier than government bonds. While government bonds are backed by the financial strength of the issuing government, corporate bonds are subject to the credit risk of the individual company. Understanding the nuances of each type of bond—such as the credit ratings, callable features, and foreign exchange risks—can help investors make more informed decisions. Whether you choose corporate or government bonds, it is crucial to conduct due diligence and consider a range of factors to maximize your returns while minimizing risk.