Are long-term U.S. government bonds risk-free?
In my opinion, there are three types of risk involved when dealing with bonds; credit risk, liquidity risk, and interest rate risk.
Are US Treasuries free of credit risk? Most likely, as a US investor, it is the best credit one can get, as if a US Treasury bond cannot make a required interest payment, or pay principal upon redemption, it would be catastrophic for the exchange value of the US dollar, and catastrophic for the US and global economy. Many other things would go horribly wrong in short order should the US default on its debts.
Are US Treasuries free of liquidity risk? Most likely, due to the US currency being a global reserve currency and sheer number of bonds traded during a normal day. Something would have to change with regard to credit (mentioned above), status as a reserve currency, or lack of US Treasury bonds on the market to create liquidity risk.
Are US Treasuries free of interest rate risk? No. As one goes further out in maturity to capture yield, the interest rate risk on any fixed rate bond increases. An investor buys a specific coupon rate for a period of time when they buy a fixed rate, fixed maturity bond. If longer-term interest rates increase, the current value of a longer-term bond decreases, and if longer-term interest rates decline, the current value of a longer-term bond increases. This relationship is based on the relative value of the interest rate the investor bought versus the interest rate that could be bought presently on similar maturity, similar quality bonds in the open market.
In my opinion, interest rate risk is where investors should focus their efforts when dealing with US Treasuries.
A fourth risk would be currency risk, but that would primarily apply to foreign investors, or US investors evaluating portfolio performance via some measure of comparative global purchasing power.
Bonds, in general, have multiple risks, but in this case we will explore the two main risks. Default risk and Interest Rate Risk.
Generally speaking, US government bonds are considered risk free, however that is simply looking at Default Risk. Therefore, when US government bonds are referred to as risk free, it should technically say Default risk free. (This may change one day but as of now this remains true).
However bonds do fluctuate in price and that can be attributed to (amongst other things) interest rates. Typically bond prices have an inverse relationship to Interest rates. If Interest rates increase, the price of a bond decreases.
In summary, if you are holding the US government bond to maturity, essentially it is considered risk free, however, if you decide to sell the bond before maturity the price could be lower (or higher) than the price you purchased the bond.
Historically, US government bonds have been considered "risk free" because the US government has never defaulted on its bonds.
However, that only addresses one dimension of risk, which is the risk of default.
When you purchase a bond, it's price will fluctuate based on a number of factors including interest rates. When interest rates rise, the price of the bond falls. When interest falls, the price of the bond rises. Hence, should you need to trade your bond, you could book a profit or a loss depending on what's happening in the market. That is true for US government bonds as well as any other bond.
Back to default risk. Even though the US has never defaulted on its bonds, its credit rating was reduced by Standard & Poors on August 5, 2011, indicating that there was a slightly higher risk of default as a result of Capital Hill politics. The rating has since been restored to AAA. It serves, however, to highlight the fact that even the bonds of the mightiest economy in the world could still be subject to default risk.
In summary, the traditional view that US government bonds are risk-free only addresses the risk of default. On that measure, most people consider the US to be (pretty) safe.
No, every type of investment involves some level of risk. People in the financial industry refer to the “risk free rate of return” and that figure is often represented by some sort of short term US Government security.
US Government securities, also known as treasury securities, are amongst the most conservative investments options available. These types of investments entail a much lower level of risk compared to traditional stock and bond investing.
The reason US Government securities are considered to have such low risk is because they are backed by the US Government and its authority to levy taxes. It is very unlikely that the US Government will default. However, because these investments entail very little risk, there isn’t much opportunity to generate much of a return.
Another way to reduce risk is by reducing the holding term, known as maturity. A Treasury Bill has the shortest maturity, usually one year or less, and therefore has the least risk. A Treasury Note matures between 2 – 10 years and a Treasury Bond (US Government Bond) between 10 – 30 years. The longer you hold a bond, the more risk there is associated with fluctuations in interest rates.
When interest rates go up (like they have recently), the price of bonds will go down. The longer the maturity of the bond, the more negatively the price will be impacted.
Stephen Rischall, CRPC
Thanks for asking this great question on Investopedia! Is anything risk-free? Not really I'm afraid. While you skip the market risk that you have with equities , there is still the spectra of interest rate risk. What do I mean by that? Well, we are at a point of extraordinarily low interest rates. That is important because the principal value of a bond generally moves in the opposite direction from the movement of interest rates. So what is the risk? If rates rise then the principal value of your bond will decline if you have to sell the bond prior to maturity. Fortunately, you can avoid this if you hold the bond to maturity. I hope that helps. Good luck!