Government or Corporate Bonds: Which would you buy?

Topic: Government or Corporate Bonds: Which would you buy?

Introduction

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        This paper seeks to analyze and discuss on whether I will choose to buy Government or Corporate Bonds.  This paper will therefore examine the characteristics of government bonds versus corporate bonds.  In am writing this paper because the knowledge that will be discovered may really help a would investor of bonds on which to choose from.  This paper will in effect explain why several kinds of government bonds do exist both in government and the corporate world.  The paper will therefore discuss the nature and purpose of bonds, as well as their classification that will lead into how to make a choice among them.

2. Analysis and Discussion

2.1 What are Bonds?

      From the point of point of view of the seller, bonds are normally long term debts or obligations to generate capitalization so other long term financial needs.  From the point of the buyer, bonds are referred to as long term investments that will receive fixed amount of interest regardless of how much the issuing the company earns.  This definition finds confirmation of what The Motley Fool (2007) said that bonds are “fixed-income” securities and that “no matter what happens or who holds the bond, it will generate exactly the same amount of money.”

2.2 What is the purpose of issuing bonds?
From the definition it could be deduced that on the part of the buyer of the bonds, it is a long term investment but on the part of the seller, bond are long term debt which may affect the long term debt structure of the issuing entity.  It is therefore a subject that is relevant to design of capital structure of the issuing company.  This paper however treats the topic more from the point view of the investor or buyer who must make a choice.  From the mind of therefore the investor, this paper starts with the assumption that he or has limited the choices to what type of bonds to invest to and that other investment options like buying stock and investing in other long term assets have eliminated or have been already carefully considered.

2.3 What are the types of bonds?

     The kinds of bonds got their definitions from the point of view of the seller of the debt.  The Motley Fool (2007) classified the first type  as referring to those  bonds sold by the U.S. government and government agencies, while the second type refer to those corporate bonds sold by corporations.  For third and four types, the Motley Fool (2007) classified them into those bonds that are those sold by state and local governments and those bonds that d by foreign governments.

       To classify the bonds broadly, I could just refer to them all as belonging to the government bonds and corporate bonds.  Belonging to the governments bonds are the first, third and fourth type, while the second type are the so called corporate bonds issued by the private sector.  In order however to be particularly responsive to the question being answered in this paper, we purposely discussed each type belonging to the broad classifications.

2.3.1 The bonds issued by the federal government and other government agencies.

       Starting with the US Federal Government bonds, The Motley Fool (2007) called them treasuries because they are sold by the Treasury Department.  Coming in a variety of different “maturities,” or lengths of time until maturity that ranging from 3 months to 30 years, treasuries are sold in the forms of Treasury notes, Treasury bills, Treasury bonds, and inflation-indexed notes.  Under this type of bonds, savings bonds as well as other types of debt are also being sold by the Treasury Department through the Bureau of the Public Debt (The Motley Fool, 2007).  These bonds are noted to vary based on maturity and amount of interest paid where debt of longer periods normally carries a higher interest rate.  As to why the disparity in the amount of interest happens could be explained by the basic general finance theory that the greater the risk the greater the return.  Long term debts are presumed to be riskier than short term debts because of the period of waiting.  It must be noted that treasuries are guaranteed by the U.S. government and are free of state and local taxes on the interest they pay (The Motley Fool, 2007), Although being guaranteed by the government and therefore they seem to be risk free, the period of waiting and the associated risks is still the best explanation to justify higher interest rates for treasuries of longer periods.

       Still part of this category or type of bonds are those bonds sold by other government agencies like the Federal National Mortgage Association, the Federal Home Loan Mortgage Corp, and the Government National Mortgage Association which sell bonds under the full faith and credit of the U.S. government for specific purposes, such as funding home ownership (The Motley Fool, 2007).

2.3.2 The bonds issued by the State and Local Governments

      One would wonder:  Why would the state or local government bonds still issue separate bonds when the federal government has already issued its own bonds?  Are the state and local government not part of the federal government?  It must be noted that these state governments are allowed by federal government to sell bonds due to deficiency of funding coming from taxes; hence they could exercise the power under their constitutions to issue bonds.  The Motley Fool (2007) explained that due to possibility of state and local governments going bankrupt, the bond sellers have to offer competitive interest rates just like corporate bonds.  The local government could not have raised taxes under its present financial plans given the economic condition; hence it is in this context that they are allowed to finance their projects by the federal government to sell bonds that are free from federal income tax on the interest paid (Motley Fool, 2007).

2.3.3 The bonds issued by the private corporations

      If government needs capital funding to finance its projects, private companies also float bonds through the public securities markets in the same manner that they sell stocks.  Having the flexibility as to how much debt it can issue and what interest rate it will pay, private corporations can make the bond attractive enough to interest investors in order to compete with the known tax-free investment and relatively risk free investment made on government bonds (Brigham and Houston, 2002) This explains the reason why corporate bonds normally carry higher interest rates than government bonds because there is a risk that the company could go bankrupt and default on the bond. This is not difficult to explain since the government can just print more money if it really needs it, while private corporations do not have such power.  Thus private corporations come up with high-yield bonds, also known as junk bonds, whose credit quality is below investment grade (The Motley Fool, 2007).  To make the bonds still attractive, corporations come up with convertible bonds (Van Horne, 1992; Brigham and Houston, 2002; Droms, 1990) to allow investors have the chance to become stockholders if certain provisions are met.

2.3.4 The bonds issued by foreign governments.

      Foreign government has their credit standing known by their economic performances which may be used as reference to the cost of their borrowing.  Hence, more economically stable countries would be able to sell bonds that pay a less amount of interest than would less economically stable ones.  Moreover, these foreign government bonds therefore competes with the interest rates that host government offers in term of its own treasury bonds and also those rates from host country’s corporate bonds, hence they must price their bonds to  be attractive enough and buyer of this type of bond normally come via mutual funds since individual buyers may not possibly allowed.

2.4 Which to choose from these bonds?

     The answer to the question is premised on the knowledge of the advantages of government bonds over corporate bonds and vice versa.  The advantage of each type over each other is already obvious in the feature of each but I am going to make it clear by analyzing and then synthesizing them.  Broadly making a choice between government govern, one should be guided by the fact the government bonds as a rule as tax-free as and less risky than corporate bonds.  On the other hand, corporate bonds are more flexible than government bonds and they also offer higher interest rates to compensate for the riskier nature of the bonds and being subjected to tax as compared to government bonds.  As how should one make a choice between these different variables is a function of attitude towards risk.  Risk-adverse investors would avoid risk and would prefer therefore to choose government bonds but risk-takes investors, both individual and corporate, my take on corporate bonds.  There are price for each choice and sometime is has something to do with other needs of the decision maker.  If one would want to eventually control a private corporation, investing in corporate bonds is the path where there is a shorter way to go.  Investing in corporate bonds which are convertible to stock could offer the chance of stock ownership which will lead to that long-planned control of that corporation as part of corporate strategy (Pearson, G., 1999; Porter, 1980).

      Another possibility is the buyers of corporate bonds could have the chance of  taking over control in case of insolvency of the issuing corporations since in the business  world the creditors are protected ahead of the owner of corporation in case of  corporate liquidations.

3. Conclusion:

      Since both government bonds and corporate bonds are ways of borrowing they are essentially similar in such respect  each category has its own features or characteristics to influence buyers, and the difference is explained by the principle of risk-return trade off in finance,  The higher the risk of the investment, the higher will be the return.  Thus, as to rates of return, corporate bonds as against government bonds offer higher rates to compensate for the risk.  As to what will cause corporate bonds to be riskier is determined by the probability that corporate bonds can go bankrupt while the federal government does not.  Since government bonds are not limited to federal government bonds a special reason must explain while municipal bonds still exist apart from federal government bonds.  The unfilled need for finances from taxes get the nod of the federal government to sell bonds but such local government to go bankrupt unlike the federal government and to compensate for the this risk they also offer higher rates than federal bonds while maintaining the tax-free feature of the bond.  Between corporate bonds and local bonds, corporate bond sellers will have to compete with the tax free provision of local bonds, thus they would have to increase the interest rate.  This is therefore the reason why under corporate bonds, there are junks banks which may be classified under a low investment grade.  In exchange for this high risk of investing, the debt holder has the chance to become stockholder of corporations either via liquation or convertible bonds under certain provision that must be complied with.

       As to how will corporate bonds compare with foreign government bonds, it must be deemed still to be governed by market forces (Carroll, 1983; Slaving, 1996; Samuelson and Nordhaus, 1992).  Individual investors might encounter difficulty in acquiring bonds sold by foreign governments; hence one must find a mutual fund if one wants to take advantage of a high-return investment that may be made available for foreign bonds.  As foreign government borrowings from other countries are still governed by the principle of  risk-return trade, the foreign government who wants to sells bonds to another company must the able to match the rates offered the federal government,  corporate and local government bonds.  Sellers of foreign government bonds must therefore normally sell at higher rates than the host government bonds and is could be lower or higher than corporate bonds depending on how investors will perceive about the level of risk that the foreign government faces.  However it must be pointed out each country has each its own economic risk and there a required cost of capital in order to survive profitably (Bernstein, 1993; Meigs and Meigs, 1995, Helfert, E.1994).  To illustrate, it is safer to buy a bond issued the government of the US bonds than any third world country in the world assuming the same bonds offer the same level of interest rate.

4. Reference:

Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia

Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK

Carroll, Thomas (1983) Microeconomic Theory Concepts and Applications, St. Martin Press, New York, USA

Droms (1990) Finance and Accounting for Non Financial Managers, Addison-Wesley Publishing Company, England

Helfert, Erich (1994), Techniques for Financial Analysis, IRWIN, Sydney, Australia

Meigs and Meigs (1995) Financial Accounting, McGraw-Hill, London, UK

Pearson, G. (1999), Strategy in Action, Prentice Hall Financial Times.

Porter (1980) Competitive Strategy, Free Press, London, UK

Samuelson and Nordhaus (1992), Economics, McGraw-Hill, Inc, London, UK

Slavin (1996) Economics, Fourth Edition, IRWIN, London, UK

The Motley Fool (2007) Investing Basics – Bonds, {www document} URL http://www.fool.com/school/basics/basics05.htm, Accessed June 9, 2007

Van Horne (1992) Financial Management and Policy, Prentice-Hall International, London, UK

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