Corporate vs. Government Bonds

Bonds and Default Risk

What separates government bonds from corporate bonds the most is the potential risk for default that each type involve. Within government bonds, there are various degrees of risk, for instance U.S. issued bonds are going to be a lot riskier than countries that are much more closer to a risk of default.

For instance, when Greece went through some very turbulent financial times, yields on their 10 year bond spiked as high as 36.591%, due to a very real concern about their defaulting. To compensate for this risk, the yield went through the roof as far as bonds go.

Since then, things have stabilized a lot more, where the yield has now dropped down to 4.132%, although this yield is still quite a bit higher than with 10 year U.S. treasury notes, which currently sit at 2.886%. The reason is that, while the situation in Greece has greatly improved, the risk of default is still considerably higher than in the U.S., where default risk over the next 10 years is virtually zero.

We go to great lengths to prevent the default of government bonds, and the Greek situation is a good example of this, perhaps even an extreme example. There is a lot more latitude that can be used to save government bonds if needed, as we saw with the Greek bonds.

With corporate bonds, companies do go under and if they do, they are usually just left to die, where bondholders then become subject to losses. Bondholders get paid first, before shareholders, and while this is certainly an advantage, there still is risk present that you will not get all of your principal back, and you never get the interest due that you lent your money to collect over time.

Just as in the case with bonds issued by different governments, there is a risk premium added to the yield of corporate bonds, with those with the least risk getting padded with the least amount of risk premium, and those which are riskier requiring a greater amount.

Some government bonds are seen as riskier than some corporate bonds though, so it’s not that we always see less risk and less risk premium with government bonds. For instance, the yield on the Indian 10 year note is over 7% these days, while quality corporate bonds of a similar length average about half of this amount.

Managing Governments vs. Corporations

Typically though, government bonds do tend to be safer than corporate bonds, and tend to pay out lower yields than even the safest corporate bonds. Changing economic conditions can simply be dealt with better by governments than by corporations, who are for the most part married to their bottom line, and do not have the ability to take on enormous amounts of debt long term.

Governments, on the other hand, even the soundest, such as the United States, just keep going more and more into debt with very little concern. Ultimately, this will be an issue, especially given the course that governments have taken in modern times. If the interest on a country’s debt becomes unmanageable, we can get to the point where we cannot just borrow out of that, and the closer we get to this point, the more the concern will be, and the higher the rates that will have to be paid will be.

Today’s levels of government borrowing are simply unsustainable, although in most cases, the horizon is far enough off that even 30 year bonds will not approach it. There are still some things that governments can do though even in the face of looming crisis, taking very inflationary measures which will devalue their existing debt, but this will end up being messy business no matter how it is approached.

Some countries are closer to being in crisis than others, and with some it’s well outside the scope of even their longest bonds, but these are things that bondholders do need to pay attention to, in order to assess the potential risk of trouble.

With corporations, the risk of their bonds depend on business circumstances, both macro and micro. The economy needs to stay good and they also need to maintain their competitive advantage to ensure that they will continue to be profitable over the terms of their bonds.

With corporate bonds, default risk means more than the company staying in business, they also need to be able to maintain the interest payments on their bonds. This is what bond default really means, not losing your money but getting to a point where interest payments need to be suspended.

Just like someone not making payments on a loan, bond issuers are responsible for making timely payments with bonds that do pay out at regular intervals, as most bonds do, and when they do not, this is when a default occurs. Not defaulting on bonds is therefore an extreme priority not only for governments but for corporations as well, and they do everything they can to prevent this.

Doing everything they can may not be enough with corporations though, as they have fairly limited means to manage this, unlike governments which can generally just borrow more to meet their obligations. This is what governments do all the time actually, not as a backup plan but as the primary plan on managing their debt obligations, but this is not something that corporations can really do.

The reason is that we expect a lot of red ink, a huge amount, with the bottom line of governments and we are not put out by this unless it reaches critical levels. With corporations, red ink does scare investors, and scares them quite a bit, and they aren’t going to lend to companies that are sinking and likely to go under.

Diversification to the Rescue

It is very fashionable to seek diversification with investments these days, and while diversification has been a goal of investors for a long time, today’s investment funds, and especially mutual funds, have taken this approach to a whole new level.

We now see bond funds holding hundreds or even thousands of different bonds, of all types. The idea here is to spread the risk around, just like one would hold everything in a stock index with an index fund.

Bond index funds work the same way as stock index funds, holding all the components of an index, and a fund may even combine a very large basket of stocks with a very large basket of bonds, which takes diversification to a whole new level, even a maximum one.

When we diversify our bonds, we can combine government bonds with corporate bonds, and even include lower quality government bonds and lower quality corporate bonds as well, and this allows us to invest in bonds that we normally may not want to consider if we were investing in them individually.

The goal here is to limit the risk of lesser quality but higher yielding bonds by mixing bonds of various qualities, and if some of the bonds default, the impact will be much less than if we were just investing in junk bonds and risky government bonds for instance.

Unlike with stocks, diversification of bonds isn’t the only way or even the best way to manage risk within an asset class, as we could just invest in so called risk free bonds to maximize this, it is to allow us to expand our expected returns and do so in a way that allows the risk of this to be managed.

There is a trade off here of course between risk and return and the addition of lower quality bonds will increase the return of the portfolio while at the same time managing the risk of the downside of these additions.

While diversification of stocks is of limited value, given that most of the risk involved in stocks is systemic risk, risk that the market itself is exposed to, bond risk is less like this, and the systemic risk involved is related to much bigger economic changes that are much more easily anticipated.

We can enter into a bear market in the stock market just because people are moving money out of the stock market into other investments, where with bonds, it takes much more to introduce systemic risk, and we can manage this quite well by adjusting our bond portfolios to contain bonds of virtually no risk, such as U.S. treasuries, if we need to.

Therefore, diversification can indeed serve to diversify our holdings to manage risk quite well with bonds, where with stocks you really need to diversify your holdings with other assets that aren’t so exposed to market risk. Bonds in fact serve to provide this additional diversity, and we can use a diversified bond portfolio to diversify both the bond holdings and other investments as well.

How Much Should We Rely on Corporate Bonds?

Just because we can use a certain type of bond to diversify our portfolio doesn’t necessarily mean we should. The drive these days is to diversify for its own sake, but we need to be careful doing that, as each addition must be justified in terms of its risk to return ratio.

While the bond market does do a good job of pricing bonds so that this is generally the case, given that we should be focusing enough on risk management with bond portfolios, we need to be careful that we do not have too much risk in them.

While fundamental analysis is of limited use in stock selection, because stock prices are driven by supply and demand and are not determined essentially by things like earnings and business performance, with bonds, fundamental analysis is very important.

While there certainly are correlations between business performance and stock prices, the two are only loosely connected, where prices often do not just mirror business results, but with bonds, the two are intimately connected.

We do want to make sure that governments are not in over their heads, like we worried that the Greeks were, and in fact the Greeks were in well over their heads, and did require a rescue, which they did get.

With corporate bonds, the health of the bonds depend entirely on the health of the company, not so much its current health, but its expected health over the life of the bond. Like predicting future stock prices, this does involve quite a bit of unknowns, and does involve some speculation, much more so than we normally would need with government bonds.

We do need to be more careful with corporate bonds, and more careful with certain government bonds as well, and the amount of risk that one may want to take on with bonds in general will depend a lot on one’s risk appetite.

This isn’t necessarily ideally served by taking a blanket approach to the bond market, owning thousands of them across bond indexes for instance, but it’s just more efficient to do it that way and therefore a lot of investors end up going with these bond funds.

Deciding whether a given bond provides value in terms of its return versus its risks, and even knowing what the risks may be, is well beyond the ability of individual investors and is challenging enough even for professional analysts.

Safety is generally the main concern among those who hold significant portions of their investment portfolios in bonds though, and risk management should be more at the forefront here, where we should be looking to choose quality over diversity. This generally means a heavier weighting of quality government bonds, and less focus on corporate bonds, and diversification with bonds by adding riskier ones to the mix does not of course manage risk, it increases it.

It is all about finding the right balance of risk and return with bonds though, which may indeed have us investing in both government and corporate bond, to seek to achieve better returns while still being comfortable with the additional risk.