Government bonds and corporate bonds have many common features: both offer fixed rate of returns, can be purchased and sold in the secondary markets before their maturity dates and offer fixed cash inflows at pre-determined dates. However, these bonds also have many differences in terms of their rate of returns, repayment schedules, risk profile, etc. Understanding these differences can help investors make informed investment decisions aligned with their financial goals and risk appetite.
Here are some of the key differences between government bonds and corporate bonds.
Issuing Entities: Government bonds in India are issued by both central government and state governments. Bonds issued by the state governments are also known as State Development Loans (SDL). Corporate bonds refer to the bonds issued by the companies, including those in the public and joint sectors. Note that bonds issued by government agencies or public sector companies are also considered as corporate bonds even if those bonds are explicitly backed by the guarantee from the promoter state or central government.
Coupon Rates: Corporate bonds usually offer higher coupon rates than government bonds of the same maturity profiles. Corporates offer this spread, i.e. additional returns, over government bonds to compensate investors for higher credit risk and default risk associated with corporate bonds. Within the corporate bonds of the same maturity profile, those having higher credit ratings offer lower coupon rates. The spread over government bonds moves incrementally as one moves down the credit spectrum. Within the similar rated corporate bonds of the same maturity profile, bonds issued by the public sector companies offer lower coupon rates due to their government ownership and thereby, their perceived or real government backing.
Interest repayment frequency: Government bonds usually make coupon payments at half yearly frequencies, based on their issue dates and maturity dates. For example, investors of a government bond issued on January 8, 2018 and maturing on January 8, 2028 would receive coupon payments January 8 and June 8 of every year during the bond tenure. In case of corporate bonds, the frequency of coupon repayment may be at monthly, quarterly, half yearly or annual intervals.
Note that zero-coupon bonds issued by both governments and corporates do not pay any coupons. Instead, the issue prices of these bonds are set lower than their respective face values and their investors receive back the face value amount on their maturity dates. There is also a bond category known as cumulative bonds wherein the accumulated coupons are paid back to the investor on their maturity dates.
Risk: Corporate bonds are considered to carry higher credit risk than government bonds. Credit risk in bonds refers to the risk of a bond issuer failing to repay their coupon or face value by their due dates. Corporates, even those having top rating in the past, can default in future due to various micro or macro-economic factors. However, governments can raise taxes or print money to avoid defaults during financial crises.
Note that just like corporate bonds, government bonds are too susceptible to interest rate risk. The prices of both government and corporate bonds react to changing interest rates or inflation regimes. The impact is higher on bonds having longer maturity profiles.
Credit Ratings: As per the SEBI regulations, listed corporate bonds have to be assigned credit ratings by SEBI-registered credit rating agencies. These ratings indicate the chances of a bond issuer repaying or defaulting its interest or principal repayment commitments. These ratings are denoted by alphanumeric symbols from ‘AAA’ to ‘D’, with ‘AAA’ denoting the highest credit rating while ‘D’ denoting the lowest rating i.e. for bonds which have already defaulted or are expected to default soon.
Credit rating agencies in India do not assign ratings to government bonds, as these are backed by sovereign guarantee. Even the bonds issued by the state governments, also known as State Development Loans (SDL), do not have the rating requirements. However, bonds issued by state and central agencies or public sector companies have to be rated by credit rating agencies, even if those bonds carry explicit guarantee from the promoter government.
Taxation of interest income: The interest income accrued from both government and corporate bonds are taxed as per the income tax slab of the investor. However, tax free bonds issued by select public sector companies and government agencies are exempt from income tax under Section 10 of the Income Tax Act. However, bond holders can claim this tax benefit only if their name and the number of tax-free bonds held by them are registered with the bond issuing entity.
Regulatory Framework: Government bonds come under the regulatory jurisdiction of the RBI whereas corporate bonds, including those issued by public sector companies and government agencies, are regulated by the SEBI.
Which is better: Corporate bonds or Government bonds
The decision to choose between corporate and government bonds should be based on your risk appetite, investment goals and market/economic cycles.
Risk-averse investors prioritising capital preservation should prefer government bonds due to their sovereign guarantee. To eliminate the risk arising from hardening inflation or interest rates, they should try to remain invested till the maturity dates of their bonds.
Investors seeking higher returns at manageable risk should prefer corporate bonds or PSU bonds offering higher returns in exchange for the increased risk. While doing so, they should prefer bonds having higher ratings, at least those rated A & above. They can choose from the lower end of the credit rating spectrum only if they have adequate risk appetite for earning higher yields.
Investors can consider a balanced combination of both government and corporate bonds for generating higher risk-adjusted interest income. They should also adjust their allocations across various bond types as per the changing economic and market cycles. They can opt for higher exposure to corporate bonds during growth cycles and favour government bonds during economic downturns.