For any debt obligation to be considered completely risk-free, investors must have full faith that the principal and interest will be paid in full and in a timely manner. The faith aspect of a debt obligation is measured by a country's credit rating. Much like an individual's credit rating is determined by his or her borrowing and repayment history, so too are governments' financial histories scrutinized. From time to time, governments will borrow funds from other countries and investors through loans and bonds. The servicing and repayment of these bonds are carefully measured by financial institutions for creditworthiness. Specifically, these financial institutions look at a government's lending and repayment history, the level of outstanding debt and the strength of its economy.
One of the most popular credit rating companies, Standard and Poor's, has given the U.S. government its second highest possible rating: AA+. Because U.S. government bonds are backed by the U.S. government and the U.S. has the most powerful economy in the world, these bonds are widely considered to be risk-free. When you purchase this type of bond, the U.S. government is guaranteeing that the interest and principal will be paid according to the bond covenants. That is, they are guaranteeing that payments will be paid on time and in full.
Only a monumental downturn in the economy or, possibly, a very rare circumstance during a time of war would prevent the U.S. government from repaying its short- or long-term debts. However, even such events are unlikely to result in the U.S. government defaulting, since it has the ability to print additional money (monetary policy) or increase taxes (fiscal policy) if additional capital is needed.
(To learn more about federal bond issues, check out our article Basics of Federal Bond Issues.)
Peter J. Creedon, CFP®, ChFC®, CLU®
Crystal Brook Advisors, New York, NY
Many people consider U.S. government bonds as “risk-free” because there is a very slim perceived chance that the country will default.
In my opinion, interest rate risk is currently the greater concern. The coupon payments the U.S. government will pay you is fixed at issuance, but the markets may create volatility for the issue that will cause the bond price (principal) to rise and fall during the life (term) of the bond. If the market interest rate fluctuates while your coupon is fixed, this may cause your investment to change in value. Also, if you choose to sell your bond before maturity you may experience a decline of principal.
Like all investments, risk is an integral part of the process. Invest with knowledge, so you know what your risks are and their effects on your capital.