Government Bonds vs. Corporate Bonds
They're both 'bonds,' yet some pay low interest and others high. That difference starts with who borrows the money—that is, whether the issuer is a government or a company.
Bonds are divided by 'who borrows'
A bond is an IOU that promises 'I will pay interest and repay the principal by a certain date' in exchange for borrowing money. But its character changes completely depending on who makes that promise.
A government bond is a bond issued by a government. A government can collect taxes and, if it's in its own currency, can even print money to repay if needed, so it's rated as having very low risk of not being paid back (credit risk).
A corporate bond is a bond issued by a company. A company can't collect taxes or print money like a government, so if its business struggles it may fail to pay interest or principal. That's why it tends to carry more default risk than a government bond.
More risk means more interest: the yield premium
Because corporate bonds are riskier than government bonds, they have to pay more interest to attract investors. This 'extra interest' is called the yield premium, or the spread over government bonds.
The calculation is simple. Subtract the government-bond yield from the corporate-bond yield of the same maturity. For example, if a 10-year corporate bond yields 5% a year and a government bond of the same maturity yields 4% a year, the spread is 1 percentage point (=100bp).
Broadly, investment-grade (high-quality) corporate bonds tend to yield roughly 0.5-1.5 percentage points (50-150bp) more than a same-maturity government bond, while high-yield (speculative-grade) corporate bonds tend to yield about 2-6 percentage points (200-600bp) more. This extra interest is exactly 'the reward for taking on greater risk.'
The spread range varies greatly with market conditions. The figures above are rough tendencies, and during crises spreads widen far more. (Source: composite of Forbes, PIMCO, Coutts)
The myth that 'government bonds are unconditionally safe'
It's true that government bonds carry lower default risk than corporate bonds. But 'government bond = 100% safe' is not true.
First, government bonds issued in a foreign currency rather than one's own currency, or the government bonds of fiscally weak countries, have actually defaulted in history.
Second, even without a default, when rates rise the prices of already-issued bonds fall. Government bonds are no exception, so during periods of surging rates, even those who invested in government bonds can suffer valuation losses.
Conversely, corporate bonds carry more risk but pay correspondingly more interest. It's not that one is 'good'; it's that the sizes of risk and reward differ.
How large a bond's default risk is can be gauged from its credit rating. Historically, the lower the rating, the sharply higher the default rate has been.
Preguntas frecuentes
Q. Do government bonds never lose principal?
Developed-country government bonds issued in their own currency have very low default risk, but 'never' is not the word. The government bonds of fiscally weak countries, or foreign-currency-denominated government bonds, have defaulted before, and even without a default, if rates rise the bond's price falls, so you can take a loss if you sell midway. 'Low default risk' and 'no losses' are different stories.
Q. Since corporate bonds pay high interest, aren't they always a good deal?
High interest is not 'free'; it's compensation for greater risk. If a company struggles, you may not receive interest or principal, and speculative-grade corporate bonds in particular have quite high default rates. The amount lost to a default can exceed the extra interest you receive, so you shouldn't judge by the interest rate alone.
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