Are Government Bonds No Risk Investments?
In turbulent financial times, people look for risk-free investments as a safe haven for their money while earning a return. However, in the market there is no return without some degree of risk. While government bonds, particularly those of the United States Treasury, are about as risk-free as it gets, there is still some risk involved in holding them.
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History
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Government bonds are sold by governments to fund their debt. They are backed by the creditworthiness of the government that issues them. U.S. Treasury bonds are popular investment vehicles for anyone looking for a secure place to invest money because government bonds are at minimal risk for default. However, because these bonds are so secure, they do not offer as high a return or yield as other forms of investments, such as stocks.
Considerations
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Even though there is little to no risk of default, government bonds are not risk-free. Bonds generally offer a set rate of return over the life of the bond. If interest rates and returns from other investments are low at the time, the bond becomes attractive because it is outperforming the market and is sellable at a high price. If interest rates and other investment returns are high, then the bond is underperforming compared to the market and will not sell at a high price. The holder of the bond is losing money compared to what he could be earning elsewhere. This is referred to as the interest rate risk.
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Time Frame
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The longer the term of the bond, the higher the interest rate risk because there's more time for the market to fluctuate compared to the stable rate of return offered by the bond. This calls for greater speculation on the investor's part, which translates to risk. This makes government bonds just as subject to interest rate risk as any other bond, even though the promised rate of return is guaranteed.
Inflation
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Government bonds are also subject to inflation risk. When currency inflates, a dollar decreases in value. With set returns, this changes the real amount of the bond's return. Inflation can even give a government bond a negative return. If a government bond has a return of 2 percent a year, but inflation grows by 3 percent, the bond's return is -1 percent. Governments often try to keep inflation to a minimum, which indirectly helps to protect the value of their bonds. The longer the bond term, the greater the risk.
Taxes
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Legislative risk is another factor to consider. One of the biggest benefits of government bonds is the fact that their returns are nontaxable. This makes the lower returns of government bonds more attractive compared to the after-tax returns of other investments. Since legislators determine what is and isn't taxable, they could decide to reduce the taxes on other investment returns or remove the tax-exempt status of government bond returns.
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References
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