Name: Ibrahim Bakhishli

ID: A0002564183

Course: Fixed Income Securities

Professor: Gaurango Banerjee, Ph.D., CFA

Topic: Introduction to Fixed Income Securities.

Government bonds (also called “Sovereign bonds”) are generally considered one of the safest
investment options available in the financial market, since they are guaranteed by governments
themselves. For these bonds to default, the issuing country itself needs to default which is highly
unlikely, but not impossible. Although, there are definitely some risks associated with sovereign bonds,
most of the professionals in the field of investment call these bonds “risk free” securities. Depending on
the economic performance and outlook of the specific country which determines its credit rating, yields
on those bonds can differ significantly. Considering the fact that the US economy is, without doubt, one
the biggest and strongest economy in the world, debt securities issued by the US Treasury is among the
highest rated securities available in the financial market. Below you can see bond yields for federal
government treasury securities ranging from 3 months to 30 year maturities.

Figure 1. US Treasury yield curve with the maturity from 3 months to 30 years. (Source: U.S. Department of
Treasury)

From the figure, we can clearly notice the relationship between maturity of the securities
and their yields. Longer it gets for a security to mature, higher the yield will be considering all
else equal.

A) There are a few companies that have the same credit rating as the U.S. government.
However, if we compare yields of the bonds issued by those companies with the U.S.
 Treasury yields, we can clearly see the difference. For example, recent 20 year bond (AAA
rated by S&P) issued by Microsoft has a yield of 3.78% while U.S. Treasury bond with the
same maturity has a yield of only 2.71% (Market Insider). Although the two bonds rated as
the highest quality securities, the one issued by the federal government has lower yield,
meaning lower risk. “Yield spread” that the corporate bond has indicates that the two
securities are not considered alternative investment options. Despite the rarity of default in
these high rated bonds, in the event of financial scarcity federal government has the option
printing money which these bonds almost “risk free”. As the credit rating of a company
deteriorates, prices for bonds issued by the company decreases increasing the yields.
Market players (“risk takers”) who invest in lower quality corporate bonds expect higher
yields for higher risk they are willing to undertake. Beyond the obvious desire of getting rich
fast by taking risks, the reasons behind investing in a junk corporate bond could be either
investor’s personal trust in a company or access to information that is not publicly available.
B) Below we can see Municipal bond yields in comparison with U.S. Treasury securities:

Figure 2. U.S. Treasury Securities vs Municipal Bonds, 2 to 30 year maturities (Source: Bloomberg )

As it’s shown in Figure 2, yields on municipal bonds are lower than those of Treasury securities
with the relevant maturities. This is mainly because the former offers tax free interest to
investors, while the interest on Treasury securities are taxable. Despite the government
insurance tax burden makes the investors require higher yields for Treasury Securities.