Which is Riskier Investment: Corporate Bonds or Government Bonds?
Exploit the studies that shed some light on which investment is riskier between corporate bonds or government bonds, and why, in order to make prudent financial judgments.
Introduction: Identifying the Problem
In case of investment, it is important to know about the risk involved. As a type of fixed-income security, bonds help to generate interest revenues over the long-term as well as to retain capital. Nevertheless, various categories of bonds have a varied degree of risk attached to them.
One of the questions that investors often ask is; Which between corporate and government bonds is a riskier investment? Why?” This article will discuss the different factors affecting the risk profile of corporate bonds and government bonds so that you make an informed investment decision.
What Are Corporate Bonds?
Corporate bond is a debt security that firms issue to capitalize. By buying corporate bonds, you are supplying money to a business, in anticipation of receiving some regular bits of interest in addition to regaining the money back at some stipulated level of maturity.
Companies of all financial capacities, such as large multinational corporations to smaller and medium-sized, growing firms issue these bonds, respectively.
Risk Factors in Corporate Bonds
Investing in corporate bonds have certain risks which also depend on the financial performance of the company issuing these bonds. A few of the risk factors are most common:
- Credit Risk (Default Risk):
Corporate bonds are exposed to the risk of the issuing firm defaulting in its debt responsibility either through defaulting in interest payments or reimbursement of the reimbursement value in maturity. Companies of lesser credit scores are riskier since they have more chances to default. - Interest Rate Risk:
Similar to any other bond, the change of interest rate also influences the corporate bonds. As interest rates increase, the price of the bonds normally decreases, and vice versa. Longer-term corporate bonds are the responsibility of the level of responsiveness to rate change. - Liquidity Risk:
Corporate bonds will not necessarily have the liquidity of government bonds, some of them, particularly small firm issues, less so. This implies that in case of necessity there may be a significant concession required to sell the bond in the secondary market.
What Are Government Bonds?
National governments issue their Government bonds to finance their expenses and activities. Investors in these bonds would normally view these investments as having lesser risk than in corporate bonds since these are primarily pegged on the credit rating and taxation capability of the government. Bonders normally get interest earned in intervals and they assure the investor of payback of capital at maturity.
Risk Factors in Government Bonds
Even although government bonds are safer than corporate bonds, the latter also have a certain risk, such as:
- Sovereign Risk:
Sovereign risk can be explained as an option that a government can default and miss repayment of its bonds because of economic unbalances amongst other factors. The risk is costlier in the developing nations or countries that have poor fiscal management. - Interest Rate Risk:
Just like corporate bonds, government bonds are subject to fluctuations in the rate of interest. Government long-term bonds are also more adapted to interest rate advances and are susceptible to these changes in the market price. - Inflation Risk:
There is inflation risk to government bonds, especially long-term bonds. In case inflation rises, the real interest on the government bonds (after the adjustment to inflation) can be less than the anticipated levels and reduce interest pay inflation, as it puts downward stress on interest payments.
Corporate Bonds vs. Government Bonds: Risk Comparison
Comparing the two kinds of bonds according to their risk factors will be useful in answering the following question: Which one is riskier to invest in; corporate bonds, or government bonds?
1. Credit Risk vs. Sovereign Risk
Credit risk is one of the main risks that can be presented by the corporate bonds. Although government bonds are perceived to be safe investments, the quality of the government issuing it comes into play. The sovereign risk tends to be low in developed countries such as the U.S, but it rises in countries with unstable economies.
To the contrary, corporations of different credit ratings can issue corporate bonds, and investors might be at risk of a larger range of risk. The financial health of a corporation is more directly relevant to its actual ability to repay debt, and may change more variably than the financial health of a government.
2. Liquidity Risk
The other factor that tends to make corporate bond riskier is liquidity. A liquid bond market means that it can be difficult to resell the bonds without a discount in prices especially in smaller companies. Government bonds, notably those of stable countries are on the other hand highly liquid, and can be sold easily in the market.
3. Interest Rate Sensitivity
The interest rate can impact both corporate and government bonds, however, corporate bonds can be more responsive to changes and bond ratings lower-rated. It is given that they have higher credit risk. The corporate bonds might attract higher yields by investors to counter the incremental risk and therefore are more volatile in an upsurge in interest rates environment.
The Risk-Return Tradeoff: Which Bond is Right for You?
Generally, corporate bonds are regarded to be riskier as compared to government bonds. The main explanation behind this is that corporate bonds are more prone to default thus the more risk the bonds are likely to experience particularly when dealing with the bonds issued by corporations with low credit ratings.
Nevertheless, this added risk is usually balanced with the possible returns as Corporate bonds yield a higher interest rate than government bonds.
The government bonds, however, could be considered a safer investment especially the ones of less developed countries. The rates attached to such bonds are lower, and thus, they provide protection to their holders (windows 10 product key) against uncertainty, which is a good point of interest to conservative investors wanting to save their funds.
How to Manage the Risks
Both types of bonds carry risks, but there are strategies you can use to manage them:
- Diversification:
Having a combination of corporate and government bonds in your portfolio will allow you to minimize the risk in your portfolio. Corporate bonds may yield more returns as compared to government bonds which may be very stable. - Credit Research:
It is paramount to do background research regarding the ratings and the financial position of the firms that issue corporate bonds before investing in them. Corporate bonds rated higher, i.e., as AAA or AA have lower chances of defaulting. - Duration Management:
In order to reduce interest rate risk, put into consideration the duration (or maturity) of the bonds held in your portfolio. The longer the duration of bonds, the more susceptible the bonds are to interest rate movements and the shorter the bond duration the less they are susceptible to interest rate movements.
Conclusion: Balancing Risk and Reward
When posed the question of which one is riskier, corporate bonds or government bonds, the answer does not have to be in the form of one is riskier than the other in the matter of outright performance.
This is mainly because of a default risk among the corporate issuers of these bonds in addition to other conditions such as the liquidity (microsoft office 2019) and interest rate sensitivities. Although not risk-free, government bonds are less risky since they are secured by the creditworthiness of the other governments of countries.
Surely, the decision on corporate bonds or government bonds has to be made by putting into consideration your risk profile, investment objectives and your investment timeframe. Corporate bonds can be the answer in case you are prepared to take greater risk but could earn a better income. However, in terms of safety and stability, then government bonds should be preferable.
