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Conventional wisdom says that government bonds are the safest investment there is. But the Indian government is rated only one level above junk. Aren't AAA-rated bonds of Indian companies safer? Haven't there been examples of governments defaulting, delaying payment and imposing haircuts on investors? Greece and Argentina come to mind.

When I invest in a liquid fund, am I not better off if the fund invests solely in AAA corporate bonds, avoiding government bonds?

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If you are afraid of your government defaulting, then you also have reason to fear that your country's so-called "AAA" corporate bonds might not be a safe investment. When governments default, they often do things like:

  • Confiscate their subjects' financial assets. This can include directly seizing corporate bonds, and/or taking away the assets that the corporations were relying on to pay their bills.
  • Increase income taxes and other taxes. In extreme cases, this is not much different from confiscation.
  • Inflate the currency. This reduces the value of both government bonds and corporate bonds (that are paid in that currency).
  • Impose price controls. This can prevent corporations from doing business.
  • Impose "bank holidays", which can prevent you from receiving payments on corporate bonds.
  • "Borrow" and/or confiscate local government cash reserves.
  • Delay payment of government obligations. This can cause corporations to go bankrupt.
  • Refuse to pay government obligations, or insist on a "cramdown". This can also cause corporations to go bankrupt.

In these scenarios, it is not predictable whether government bonds will suffer more or less than any particular corporate bonds.

You might want to diversify into precious metals, foreign currencies, and/or foreign securities. For the most security, you might want to choose investment vehicles that your government would have a hard time confiscating. Of course, you will face currency fluctuation risks if you do so.

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Haven't there been examples of governments defaulting, delaying payment and imposing haircuts on investors? Greece and Argentina come to mind.

Quite a few Govt have defaulted in the past or were very of default or crisis. Most 3rd world countries or developing countries have under gone stress at some point. Greece was amongst the first example of Developed country going bankrupt.

am I not better off if the fund invests solely in AAA corporate bonds, avoiding government bonds?

Well that depends. Corporate bonds are not safer than Government Bonds. There have been instances of Corporate bonds not giving the required returns.

  • Many first-world countries have defaulted, including the United States and Germany. When the United Kingdom was ruled by the Labour Party (during most of 1945 - 1979), its inflation rate amounted to a not-so-gradual default. – Jasper Nov 30 '15 at 5:52
  • @Jasper I cannot speak for Germany or the UK, but I'm quite certain that the US has never defaulted on a bond. – user32479 Feb 20 '16 at 5:42
  • @Brick -- In 1933, the U.S. devalued the dollar with respect to gold by 40%. This was effectively a default. In 1968, the U.S. defaulted on all silver certificates -- they can no longer be redeemed for the silver promised on the certificate. In 1971, the U.S. "closed the gold window"; this effectively defaulted on U.S. dollar-denominated securities held by foreign governments. – Jasper Feb 20 '16 at 5:57
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    @Jasper While historically interesting, none of those are technically default on debt and none deal with bonds, which is the subject of the question. Still, it underscores some of the many "tricks" available to issuers of sovereign debt not available to other debtors. Default clearly isn't the only way that creditors may lose. – user32479 Feb 20 '16 at 6:23
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    @Jasper Default means something very specific. While these things you've listed can, no doubt, be bad, it's still different. A default is an action (or lack thereof) against specific bond holders. Many of these other things are broader economic / policy factors that impact a much wider class of individuals than bond holders. You may feel that's actually worse, but it's still not the same. – user32479 Feb 20 '16 at 6:40

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