BONDS #6: Basic Types of Bonds: Treasury vs. Corporate

Who needs a double decaf espresso latte with sweet ‘n low, when what you really want is just a good cup of coffee??

How about a Eurodollar, junk bond with a sinking fund and call provision? There is a bond out there to satisfy every nuance of fixed-income investing needs! But let’s get real.

With personal investments, remember to K I S S!

Keep it simple, stupid.

So, this week we will look at two of the more straightforward bond types: Treasury bonds and U.S. corporate bonds

I believe the easiest way to get a handle on subject matter is to do some basic comparisons as we go along. That way we can see the advantages of various types of securities by seeing their differences.

The self-evident difference is the issuer:

either the US government or a corporation. This is the entity that you must believe will pay your coupon interest every six months and will repay the face amount at maturity.

This raises the difference of credit rating, which we discussed in general four weeks ago. (You can click on previous articles if you missed any). The Treasury issues are AAA and backed by the “full faith and credit” of the government. Government agencies (FNMA, GNMA, etc) are not expressly guaranteed, but generally considered AAA.

Corporates are more diverse in credit, ranging from a few AAA’s to junk bonds (BB or lower). I have a strong preference for investment-grade issues (BBB, A, AA or AAA) in my retirement fund.

Why buy high-grade corporates? For me, they have a good balance between safety and yield. The yield advantage to the lower quality of corporate bonds is referred to as the spread over treasuries.

For example, I recently looked at a couple of Daimler Chrysler bonds, which are rated by Standard & Poor’s as A+ and by Moody’s as A1. The issues had coupons near 7% and they matured in about 5 years. They were offered to me at a discount (I would pay less than face value for them) and the investment would yield about 7.37%.

At the time, the 5-year Treasury bond had a yield of 6.41%.

The difference of 0.96%, or 96 basis points “over Treasuries” is the enticement a corporation must offer me to lure me away from the AAA alternative.

Big deal?

Every 1% more yield on $10,000 earns another $100 a year. If I were retired, and was supplementing my social security with the income from, say, $100,000 in bonds, that would be another $1000 a year.

This added yield also compensates me for some other differences between treasury and corporate bonds.

Aside from their safety, treasury bonds are noted for their liquidity. If you anticipate that you will need to sell your bonds before maturity, or if you want to trade them actively, the easiest issues to sell are treasuries. Treasury bonds do not go out of favor.

During times of financial crisis, there is a “flight-to-quality” and everyone rushes for the “safe haven” of treasury issues. During those times, the spread over treasuries widens, and prices for corporate bonds get cheaper. This is terrific if you want to buck the crowd and use the opportunity to buy corporates, but it can be deadly if you are forced to sell during these times. And if you hold only junk bonds, all is worse.

Also, with treasury bonds, there is not a dramatic difference between the offer price (where you bought them) and the bid price (the level at which a dealer is willing to buy them from you.) While there is always a market for high-quality corporate bonds, the difference between bid and offer is much wider than for treasury bonds. And this lessens the advantage to corporates if you intend to trade in and out, rather than buy- and-hold.

Finally, transaction fees. Treasury bonds are inexpensive to buy. You can get them directly for a nominal fee. Brokers will charge more for a purchase of a corporate issue, and this is generally offset by the higher yield. But, if you trade actively, the advantage can be eaten up with expenses. Better to buy and hold these bonds!

You should have a balance between stocks, bonds and cash. They should be balanced to provide growth, produce income and cover cash needs. But for unforeseen emergencies, have some short-term bonds, including some treasury issues, that can easily be sold.