Are long-term U.S. government bonds risk-free?
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.
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
Simple question, but a very complex issue. Every investment has risk. Risk can be small or great. Risk can be from default, credit, interest rate, market, and other types, to name a few. Default for a long term bond (10-30 years) would occur if the US Government cannot pay its bills (default) and does not have the funds to pay the interest to the holders of the debt (you the "bond holder"). There is a perceived slim chance of the US government defaulting which is one major reason the U.S. has a high credit rating and considered relatively safe for repayment. This may be why many people consider U.S. government bond investment "risk free". Bonds are usually issued in increments of $1,000 (principle).
Interest rate risk is probably a more real concern now, in my opinion. A US government bond is a debt of the US. In essence, a promise to pay you the holder of the debt, interest, in exchange for the use of the funds until a certain date in time (maturity date) when the U.S. government will return $1,000 principle to you, the bondholder. What few people realize is the bond always has a value in the market, what it can be resold for any time during the bonds life, until it matures or is recalled by the U.S. government. So a correlation usually exists between the price the bond is worth in the market and current interest rates. If interest rates stay the same, then the bond price (principle) should basically stay the same (par) over the term (life10, 30 years) of the debt (bond). The interest rate the U.S. government pays you is fixed when issued by the U.S. government, until maturity. The markets (stock/ bond) may create volatility for the issue that will cause the price (principle) in the market to rise and fall during the life (term) of the bond. Also, lets say you bought a new 30 year treasury bond that promises to pay you 2.75% a year for 30 years and the interest rates rise in a few years to 3.5%. The result of the new markets interest rate for a new government 30 year bonds similar to yours, will cause your already issued bond principle to fall (price) so your principle and interest rate you receive equal the new market issues.
The principle fluctuations usually level out as you get closer to the maturity date of the bond, but be aware if you choose to sell your bond before maturity you may experience a decline of principle (what you paid for the bond). The fluctuations of principle may be slight and you can calculate the movement, if you know how or ask a professional. If you hold your bond to maturity the U.S. Government will return $1,000 or par. So, is the bond risk free? Bonds are investments and all investments face risks and volatility of principle due to may possible factors. Hold a bond to maturity and all thing considered you should get (par) your $1,000 back. Sell during the life of the bond and there may be fluctuations in principle. Like all investments, risk is an integral part of the investment. I strongly suggest you research the different types of risks that may cause the decline or increase the principle or contact an advisor that can explain the pro's and con's of your investment. Invest with knowledge, so you know what your risks are and their effects on your principle (money). Bonds can be a very complex area and you need to do your due diligence.
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.
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!