23rd January 2019 | Jacek Starobrat | Deputy Head of Portfolio Management

Treasury bonds versus corporate bonds

Investors investing their funds in bank deposits, often wonder what the alternative may be. A fixed income investment comes with the help.

Fixed income refers to any type of investment under which the borrower may have to pay interest periodically, according to interest rate and repay the principal amount on maturity. Fixed-income securities can be compared to bank deposits. However, bank deposits are not equal and the same, from the credit risk point of view of the borrower. The similar situation applies to fixed income instruments.

From the point of view of credit risk, there are 2 main sub-asset classes among fixed income instruments:

  1. Treasury debt 
  2. Corporate debt

Treasury debt

Treasury debt or national debt includes debt issued by the state treasury or government (government agency). Credit risk is similar to the credit risk of a state and government that issues debt. The state guarantees the payment of interest and the value of the nominal debt. It does not mean, however, that the state's treasury cannot go bankrupt, but nevertheless, the credit risk of the state is generally lower than the risk of domestic entities. Therefore, treasury debt is often referred to as risk free (zero risk) and it is often used as the reference basis in financial models. However, in practice, risk-free rate doesn’t exist in a real world as even the safest investment carries a very small amount of risk. But for US based investors, for example, short-term government debt: 3-months treasury bills are often used as risk-free rate.

There are different types of government debt but the most common are government (treasury) bonds and government (treasury) bills. 

Government, treasury, sovereign bonds in general refers to debt with maturity longer than 1 year. The most common government bonds benchmarks cover 2 years, 5 years, 10 years and 30 years to maturity. Treasury bills are often short dated with maturity up to 1 year.  

As government bonds and treasury bills can be treated as risk free, the main reason for investing in this type of fixed income instruments is low credit risk and low interest rate risk, which is in fact the result of the country's credit risk assessment and the level of central bank interest rates. However, the longer maturity and duration, the interest rate risk increases. For example, for US-based investors, the most appropriate measure used as a risk-free rate is the rate of three-months US treasury bills.

Corporate debt

Corporate debt is a debt issued by corporations, private entities that finance their activities and capital expenditure needs, borrowing money from investors. There are different types of corporate debt but the most recognizable are corporate bonds and commercial papers. Corporate bonds refer to longer-dated, above 1-year maturity. Commercial papers refer to short-dated, up to 1-year maturity. 

The greatest advantage of corporate debt is exposure to the private market, which is not an equity market, and a high income resulting from high risk premium, which is generally higher than a government debt has. There are different types of risk attached to corporate debt but the most significant is credit risk. Fixed rate corporate bonds can be exposed to the interest rate risk, but the main value and reason to invest is the credit risk premium.  The credit risk premium is the return (amount), a kind of compensation, that an investor would like to earn for the risk involved. For corporate bonds it is often an extra premium added to a risk-free rate. The higher credit risk, the higher premium. It is usually expressed in the form of a bond coupon or dividend. 

Portfolio managers responsible for management of fixed income portfolios often make decisions of the allocation of funds between these two types of fixed income asset classes. In the growth phase of the business cycle, when companies are in good shape and financial condition, their revenues and profits are growing, and then corporate debt is an attractive alternative to government bonds, mainly due to two reasons:

  1. Improving situation of the national economy and subsequently credit quality of corporations means that risk of default is decreasing.
  2. Expectations for higher profits of corporations, means a greater value of corporations and better and more stable bonds value or lower credit risk.

At the start of the business cycle risk premium should be higher (better yield) because corporations must pay more for the financing. In the mid or end of the cycle risk premium will be lower for new investors buying the issued debt, because the credit risk of corporations is lower which has a positive impact for financing costs (cheaper borrowing). So, it is better to fix a better premium of the investment at the start of the cycle.

When the business cycle is in a downward phase and corporations lose their value as profits are falling, it also has a negative impact on their credit risk, and it can also negatively impact corporate bond prices.

Of course, the above example assumes that there are not any forms of public, economic, financial stimulation, quantitative easing etc. which creates expectations for a cheap financing and better market valuations in the future.

Anyway, if the equity market is in retreat, investors often "flight turns to quality" which means buying government bonds to protect their capital.

A weak economy can mean that, for example, the central bank will stimulate the economy through an interest rate policy, cutting central bank rates. It creates expectations for lower rates and yields in the future, directing the portfolio managers focus towards the interest rate risk premium, rather than credit risk premium.

Summing up

Government and corporate debt, two major fixed income sub-asset classes are the main concern of portfolio manager in terms of fixed income asset allocation. Investors investing in fixed income strategies assume a relatively lower level of risk than the equity portfolios, but the balance between the government and corporate debts can illustrate the actual level of risk/reward relationship of the fixed income portfolio.

Treasury and corporate bonds, as the main fixed income asset classes, fully reflects risk and reward spectrum of fixed income investment.

Golden Sand Bank ("Bank") exercised due diligence to ensure that the information contained in this publication was not incorrect or untrue as at the date of publication.

All Investment products are at risk, as their value can go down as well as up. The tax treatment of your investment will depend on your individual circumstances and may change in the future. If you are unsure about whether investing is right for you, please seek financial advice. This publication is not an investment recommendation or investment advice in connection with any services provided by the Bank to the Client.

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