Fixed income securities can take many forms, but the two largest bond markets open to investors are government-issued bonds and corporate bonds. Chances are, if you want to invest in bonds, you’re going to purchase one of these two types of securities.
Choosing between the two can be hard. In many ways, these investments are similar, but there are also important differences that you need to be aware of, especially when it comes to risk.
What are government bonds?
Government bonds are issued by governments and are usually denominated in the country’s currency or in US Dollar. In the UK, bonds issued by the UK government are in pounds sterling and are called gilts.
Gilts are fixed-interest securities that the British government issues when it wants to raise capital. Investors who buy gilts will get back the capital they invest upon maturity as well as receiving interest at regular intervals throughout the term.
Gilts are considered to be very low-risk because it’s unlikely that the UK Government will default and be unable to pay its liabilities to investors.
An example of a government bond
A gilt looks like this: “Treasury stock 3.5% 01/01/21”.
So if you buy this UK government bond, you would receive a coupon of 3.5% each year until the bond matures in January 2021 when you receive back the total that you originally invested.
What are corporate bonds?
A corporate bond is issued by a company seeking to raise capital.
Just like government bonds, investors who buy corporate bonds are rewarded for the risk they take with the return of the initial amount of money that they invested upon maturity and payment of interest throughout the term.
Corporate bonds are generally riskier than gilts, as a company is more likely to default than a stable government. As a result, corporate bonds offer a higher rate of interest.
An example of a corporate bond
A corporate bond looks something like this: “Netflix 5% 07/2022”.
So if you buy this bond, you receive a 5% coupon every year until the bond matures in July ‘22.
As we can see, government bonds and corporate bonds are similar in many ways. So let’s take a look at some key differences.
Of course, the key difference between the two types of bonds is who is issuing them.
Governments issue government bonds and companies issue corporate bonds. So when deciding whether to invest in government bonds or corporate bonds, you need to assess the prospects of the countries and companies that issue them.
The biggest difference between corporate bonds and government bonds is their risk profile. Corporate bonds (usually) offer a higher rate of interest because their default risk is greater.
To understand this, think about the entities issuing bonds in our examples above:
- If you invest in a UK government bond, you bet that the UK government won’t default. This seems like a good bet, as the UK economy is one of the world’s most secure. Hence, it isn’t a particularly risky investment and you are only rewarded with a low rate of interest.
- If you invest in a bond issued by Netflix, you estimate Netflix will still be in business when the bond matures. Sure, Netflix is a solid company that is performing well, but it’s hard to predict how it will perform over the long term and if things go wrong, it will be unable to print money, raise taxes or engage in other financial measures to prevent default on its liabilities – which is precisely what a government can do. So, investing in bonds issued by Netflix presents a higher risk to investors than investing in government bonds issued by well-regarded governments, like the UK, the US and Germany. As a general rule, corporate bonds usually pay a higher rate of interest because they are higher risk.
However the above isn’t always the case, some less secure countries issue bonds that are higher risk, and pay higher yields than established companies. But generally speaking, corporate bonds are higher risk and higher reward than government bonds.
Despite the similarities between government bonds and corporate bonds, it’s important that you’re aware of these differences when deciding where to invest your money, as both types of investment can fulfil a different role in your portfolio. In short, government bonds should be considered low risk and low return, whereas corporate bonds have a higher level of risk but also a higher rate of return and more choice.
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