Question

Compare and contrast a 5-year AAA corporate bond with a 5-year Treasury Note. Which would typically offer a higher interest rate? Why? What risk affects both types of bonds?

Answer 1

A bond is a financial instrument issued by a borrower which carries an interest component. It is a fixed income instrument. The interest depends on the credit worthiness of the issuer.Higher the risk, the investors in those bonds would demand higher rate of interest. Governments,Corporations,Companies,etc issue bonds to fund their growth or expenditure.

The Credit rating agencies like Standard & Poor’s,Moody’s,Fitch ,etc provide rating to issuer of such bonds primarily on the credit worthiness and financial strength and their ability to service the interest on timely basis and re-pay the funds as promised.

Standard & Poor’s and Fitch assign ratings like “AAA” “BBB-“ which signifies the credit worthiness of the issuer.AAA is the highest form of rating. It signifies that the issuer has high degree of credit worthiness and will meet the interest payment commitment on a timely basis and has a lower risk of default. A high rated bond will offer less interest rate and hence the cost of borrowing for a company which has sound financial strength will have lower cost of borrowing as compared to a company with lower ratings.

Similarly, Governments of different countries also issue Bonds which is known as Treasury bills or G-Sec (Government Securities) to fund their expenditures and run the welfare schemes for betterment of the society. Taxes are the prime source of income for a government from where they run the country . But the taxes collected may not be able to cover all the expenditure like – infrastructure,housing, and so on, hence governments also issue 5 year or 10 year long term bonds to fund these projects. Like corporate bonds, these bonds also carry certain rate of interest but it is generally lower than what the corporate bonds offer since the prime assumption is that governments will not default on payment of interest or in principal. However, there have been instances in real world ,where in countires like Portugal, Iceland, Greece, Spain and others could not honor their commitment and defaulted on re-payment. Some of them had to be bailed out by organizations like World Bank, IMF.

Therefore, similarity between a 5 Year AAA corporate bond and a 5 year treasury note would be –

1. Both are issued to fund expenditure and growth by corporate and government respectively.
2. Both carry certain rate of interest which is payable in regular interval as per the terms mentioned
3. Probability of default by the issuer is less, therefore less risky
4. High credit worthiness
5. Rate of interest offered will be lower compared to lower rated bonds

Similarly , the difference between a 5 Year AAA corporate bond and a 5 year treasury note would be –

1. AAA corporate bonds are issued by companies where as Treasury bills are issued by governments
2. Treasury bills are considered risk free but corporate bonds carries risk
3. AAA corporate bonds offer comparatively higher rate of interest than the treasury bills
4. Treasury bills are less volatile and offer greater liquidity

Risk of default and non payment of interest and principal affects both type of bonds. If a government defaults in payment then the citizens of that country may lose faith in the ability of the government to run the country smoothly. And when a AAA rated companies defaults, people will lose faith in ratings and will be hesitant to subscribe to bonds on fear of losing money.