What is the difference between government bonds and corporate bonds?
13 May 2019
Risk is unfortunately an unavoidable aspect of any investment, which is why the golden rule of a good strategy is diversification. In the bond market this means choosing both government bonds and corporate bonds. But what are they? And how do they differ? Let’s take a closer look.
What are bonds?
Bonds are securities that represent a portion of the debt issued by a company or a public entity in order to obtain funding. When a bond matures (at the end of a pre-defined period), the principal is repaid to the bondholder, plus interest (this is the amount the bondholder earns in exchange for the sum invested).
Bonds are issued in order to obtain capital to invest directly from investors at a better rate than a bank loan. In other words, bond issuers generally obtain lower interest rates than if they borrow money from a bank. Conversely, investors receive a higher rate than they would get on a cash investment, and have the option to sell their investment on the secondary market.
Definition and characteristics of government bonds
Government bonds are securities issued by a public entity or a national government (these are also called sovereign bonds). Governments use these loans to fund new initiatives or infrastructure, while for investors, they are a source of returns.
When investors buy government bonds they are lending a government or public entity an agreed sum of money for a specific period. In exchange, the government makes regular interest payments to the bondholder, at a pre-determined rate. These payments are called coupons. Government bonds therefore provide a steady source of income.
On the bond’s maturity date, the full amount of the initial investment is repaid. Different bonds have different maturity dates, which can range from 6 months to 30 years or more. In the same way as equities, government bonds can be held for investment purposes or sold on the market to other traders.
Some investors consider government bonds to be a risk-free investment. Since, in theory, governments can print money to service their debts, they should always be able to fulfil the repayments when bonds mature. However, there are risks attached to government bonds, as well as other potential drawbacks to bear in mind, such as interest rate, inflation and currency risks. Nonetheless, government bonds are less risky than corporate bonds.
Definition and characteristics of corporate bonds
Companies may also issue bonds under certain conditions that are very similar to government bonds. These are called corporate bonds. In this case, however, investors lend money to private-sector companies that have decided to raise capital by issuing debt securities (i.e. bonds) rather than shares.
Corporate bonds work in the same way as government bonds: a loan is given to a company in exchange for interest and the full repayment of capital at the end of a pre-defined period.
Differences between government bonds and corporate bonds
Now that we have explained the various characteristics of government and corporate bonds, we can look at how they differ.
A major difference is liquidity, which will be much lower for corporate bonds, since the volumes of government bonds issued are much higher.
Another difference is the minimum investment. In a government bond issue, the minimum investment may be €1,000, whereas for most corporate bonds it would be at least €50,000.
Lastly, the tax treatment is different: the tax rate on corporate bonds was increased to 20% in 2012 but remained at 12.5% for government bonds.
A safer bet is to invest in a bond fund
As may be surmised, investing in the bond market requires analysis and expertise. It is therefore advisable to use a professional company with the experience to choose the best government and corporate bonds.
The most effective way of diversifying investments and maximising returns is to select a bond fund managed by expert professionals.
(To find out more about the Tendercapital funds that invest in the bond market, such as TenderCapital Bond Two Steps, click here).