Andras Crow-Hreidar 
When it comes to investing in bonds it’s important to differentiate between corporate bonds vs government bonds . Historically corporate bonds have provided slightly higher pre-tax returns due to factors such as tax premiums, liquidity premiums and the risk associated with corporate debt . But the impact of these factors on portfolio returns can be different than expected .
The Role of Bonds in Reducing Portfolio Volatility
One of the main reasons investors include bonds in their portfolios alongside equities is to reduce volatility . Bonds have a negative correlation or no correlation to equities on average which helps balance the portfolio . Over the past three decades long-term treasury bonds have shown a reliable negative correlation to stocks while corporate bonds have shown a much weaker correlation .
Flight to Safety and Crisis Alpha
During times of market turmoil like the 2008 Global Financial Crisis, government bonds especially treasury bond tend to act as a safe haven for investors . This flight to safety phenomenon increases the negative correlation between treasury bonds and stocks . On the other hand corporate bonds have shown liquidity risks and may not provide the expected downside protection during market crashes .
Credit Risk and Default Risk
Corporate bonds carry credit risk in nature as there is a possibility of companies defaulting on their debt obligations . This risk becomes more significant during times of crisis . In contrast U .S . treasury bonds have virtually zero default risk as they are backed by the government’s full faith and credit . The lower credit risk of treasury bonds adds to their appeal as a diversification tool .
Considerations in a Taxable Environment and Municipal Bonds
In a taxable environment interest from treasury bonds is tax-free at the state and local levels which provides an additional advantage over corporate bonds . Municipal bonds offer federal-tax-free interest but they act similarly to corporate bonds during market crashes and may not offer significant protection .
Portfolio Allocation and Preferences
Corporate bonds may be preferred in certain scenarios such as when investors desire more risk/reward within their bond allocation or when looking for income through high-yield corporate bond funds . However for long-term diversified portfolios government bonds are generally more favorable due to their superior volatility reduction, downside protection and avoidance of credit risk, liquidity risk and default risk .
Total Bond Market Funds and Portfolio Diversification
Total bond market funds typically contain a mix of corporate and government debt and they may be chosen for convenience or lack of awareness regarding their composition . But diversifying within the bond asset class does not necessarily add to overall portfolio diversification . Investors should consider government bond funds as a solution for a more focused allocation to treasury bonds .
Making Informed Investment Choices
Understanding the differences between corporate bonds and government bonds can help investors assess their fixed income allocation . Government bonds offer superior risk profiles, lower correlations to stocks and crisis alpha benefits during market downturns . This information should prompt investors to evaluate their portfolio’s fixed income allocation and consider the advantages of government bonds .
Final Thoughts
When constructing a well-diversified portfolio for the long term government bonds are generally preferable to corporate bonds thanks to their ability to reduce volatility and provide downside protection . Government bonds offer advantages such as tax-free interest, avoidance of credit and default risk and increased crisis alpha during market crashes . Through incorporating government bonds investors can build a more strong and resilient investment strategy .
