Understanding Risk-Free Assets: A Beginner's Guide
Some investors have become afraid of volatility in the markets and wish to reduce the risk in their investments. Treasury securities for example provide safety in an investor's portfolio and are considered risk-free.
Typically, someone with a low-risk tolerance may stay away from stocks in the short term and favors u.s. Treasurys. Whilst no financial asset is 100% risk-free, investing in treasury bills, notes, or bonds is a good strategy to help balance a diversified portfolio in times of expected turmoil.
Treasuries however generally do not yield much in return and can limit your ability to meet your goals; in some cases, you may even risk to lose money. When the economy slows down, they become in demand with investors looking for security and an expected rate of return for their investment.
Let's dive into our beginner's guide to understanding risk-free assets.
Table of Contents
- Types of Treasurys
- Should you invest in a risk-free asset?
- In a theoretical world with no inflation, your best risk-free investment is in Treasury bills issued by the U.S. government
- Inflation reduces your purchasing power
- Low risk = low return?
- Not free from volatility
Types of Treasurys
A distinguishable feature in Treasurys is just how long the term is (maturity date), and the expected future rate of return, in addition to their risk-free nature. As a general rule, the longer the term, the higher the interest rate will be. However, the yield curve in 2022 was inverted with most short-term bills now offering higher interest rates than longer-term bonds.
Treasury Bills (or T-bills)
Treasury bills are short-term assets, sold in several different maturities; the most common bill durations are 4, 8, 13, 17, 26, or 52 weeks. T-bills can be purchased at discounted face value prices; then when the bill matures, you receive the full value. For example, you can invest $475 and receive a face value of $ 500 at maturity.
Treasury notes are medium-term government debt securities, dated between 2 to 10 years. Interest rates on Treasury notes are fixed, and paid twice a year; it is never less than 0.125%.
The longer-period notes can offer a return of over 4% - risk-free, making it an interesting proposition to invest in for cautious investors.
Treasury bonds have a long-term maturity of 10 to 30 years. They are issued with a fixed interest rate called a coupon and are paid semi-annually.
The bond price can be higher (sold at a premium) or lower (sold at a discount) than the face value, depending on market demand.
There are also Treasury Inflation-Protected Security (TIPS), which are essentially bonds modified over time to keep up with inflation.
Whilst the risk-free aspect cannot be ignored, the current 30-year bond return doesn't look like the best place for cash right now.
For all 3 types of Treasurys, you can hold them until they mature, or sell them before maturity.
Should you invest in a risk-free asset?
A risk-free asset carries the assumption that the bill is unlikely to default, a key difference with stocks. But being able to anticipate the future return is directly related to the interest rate risk, which tends to be one of the lowest returns.
Whether treasuries are right for you depends on the financial objectives you want to reach with your portfolio. Typically a young investor should not worry about short-term price movements in the stock market and can afford to take some risk in the hope of a higher return. By default, there is nothing wrong with investing a small portion of your portfolio in risk-free assets.
On the other hand, conservative investors, or those nearing retirement for example, will prefer the safety provided by low-risk investments. Treasurys are still better than leaving your cash in a no-interest account! They provide a stable source of income that is not dependent on the stock market.
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In a theoretical world with no inflation, your best risk-free investment is in Treasury bills issued by the U.S. government
Treasury notes and bonds issued by the U.S. government are considered risk-free assets because they are backed by the full faith and credit of the U.S., which has never defaulted on its debt obligations in modern history.
If you're an individual investor, you can purchase Treasury bills (T-bill) online through your brokerage account or directly through Treasury Direct. These are not subject to local or state taxes but tax is due to the federal government on interest earned.Did you read Why the Stock Market Should Be On Your Radar: A Guide For First-Time Investors
Inflation reduces your purchasing power
People often use the term "risk-free asset" to refer to Treasurys that are guaranteed by the government. In this case, we're talking about a U.S. Treasury bond that is issued by the federal government and pays a fixed rate of interest (but not necessarily a high return). The main benefit of investing in these bonds is that you know exactly how much money you will receive at regular intervals until they mature.
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However, considering inflation risk and the rapid interest rate changes we've witnessed in the economy, if you lock your funds for 20 years for instance, you might end up losing money as your purchasing power decreases with inflation.
Indeed, bond prices usually come down when interest rates go up, and vice versa. As with any investments, talk to a financial professional or even to your account manager for guidance. Being risk-free doesn't mean you should be careless with your hard-earned money!
You can follow the current rate of return for U.S. Treasurys here.
Low risk = low return?
Risk-free assets are also known as "fixed-income securities" because they offer a defined rate of return. You purchase these with the expectation that your risk-free investment will earn a little bit of interest over time.
These securities can be of various types:
Corporate bonds are sold by financial institutions or corporations to raise capital for loans, mortgages, or other projects. These assets offer a theoretical yield higher than traditional bonds but their credit risk is greater; as some companies may not be financially sound or have little-to-no financial history. There is more than meets the eye with high-interest rates, carefully evaluate the risk.
Government-issued notes and bonds that have medium to long-term maturity. They usually carry an interest rate higher than shorter-term debt instruments (such as Treasury bills) and are defined as risk-free.
Municipal bonds are debt issued by a municipality or state to fund public works. Like other bonds, investors lend money to the issuer for a set period. This is usually low-risk, but not risk-free.
Not free from volatility
Perhaps the biggest drawback of risk-free Treasurys is their volatility, as their market value is subject to significant movement over time, caused by inflation, uncertainty in the economy, or changing market conditions.Going up
If you have locked into a bond for 30 years, you could still turn around and sell it for more than what you purchased it for, if interest rates have fallen. In this case, a bondholder may be able to close at a premium above par.Going down
If the interest rate on newly issued bonds is higher than your bond's current interest rate, then you will notice the price of your bond go down, a risk often overlooked. This is because investors are not willing to pay as much for a lower-paying investment when they have other options available with better returns.
The 10 Year Treasury Rate is the yield received for investing in a US government-issued treasury security that has a maturity of 10 years. You can see the chart here.
If you are looking for a risk-free investment, Treasurys can be a good option; bearing in mind that nothing is 100% safe. Therefore, these investments should be viewed as risk-neutral assets rather than completely risk-free assets; indeed, there is still some risk involved when selling them before maturity due to fluctuations in the market price — just like any other asset class.
Whilst a Treasury bond yields more today than a few years ago, there isn't such thing as a perfect income investment, so consider all the advantages and disadvantages before investing.
In addition, there's always the possibility that inflation could affect the purchasing power of these securities over time. With a long-term mindset and a diversified approach, generally, bonds are stable and risk-free investment assets for your portfolio.
No Financial Advice. This article does not provide financial advice and has been prepared without taking into account any person’s investment objectives, financial situation, risk tolerance, or particular needs.
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