A possible choice for income investors is to compare long-term government bonds to corporate bonds. The best choice for an individual investor depends on the investor's financial goals and outlook concerning interest rates and the economy. Different circumstances can make one bond type more appropriate than the other.
Long-term U.S. Treasury bonds are bonds issued by the federal government with maturities of 10 to 30 years. Government-issued Treasury securities are considered to be the safest bond investments. The safety of corporate bonds depends on the credit rating of the bond issuer. Corporate bonds with a AAA credit rating will be almost as safe as Treasury bonds. Corporate bonds rated BBB or lower are considered to be non-investment grade and have a significant risk of default on interest and/or principal payments.
As the safest form of debt securities, the yield earned from government bonds will be less than from corporate bonds. AAA-rated corporate bonds will yield just above Treasury bonds, and the yield will increase as a bond's credit rating gets lower. Non-investment grade junk bonds often yield 4 to 6 percent higher than Treasury bonds. Investors selecting corporate bond should make sure they get enough yield premium above the comparable Treasury bond rate to justify the extra risk.
Buying, Selling and Evaluating
For an individual investor, buying and selling government bonds is easier and less risky than purchasing corporate bonds. Treasury securities can be purchased without cost through the Treasury Direct website, and the very large and liquid market for government bonds makes current yields and prices easy to research. Corporate bond information is harder to find, and it is difficult for an individual investor to determine a good price for a specific corporate issue. Corporate bonds are often best invested in through mutual funds.
The interest earned from corporate bonds is fully taxable. An investor will pay both federal and state income taxes. The interest from U.S. Treasury bonds is federally taxable, but is exempt from state income taxes. The corporate bond taxable equivalent yield for Treasury bond is calculated by dividing the Treasury rate by one minus the state income tax rate. For example assume Treasury bonds are paying 5 percent, and an investor lives in a state with a 6 percent income tax rate. A corporate bond must pay more than 5.32 percent to provide a higher after tax yield than the Treasury bond.
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