The Good ole U.S. Treasury Bonds, Bills, and Notes
Historically, some of the most popular investments are the United States Treasury bonds, bills, and notes. While these bonds bring back memories of bond certificates in Grandma's safe deposit box, there are several misconceptions about U.S. treasury issues that are commonplace. In this entry, we will address some of these investing misnomers, and parlay that knowledge into today's bond market.
"When you buy a Treasury security, you are actually lending the government money for a set period of time, from 30 days to 30 years, at a fixed rate of interest."
U.S. Bonds. What you Absolutely Must Know About these Securities
To answer this question, let's first look at an entry from Yahoo Finance about these savings vehicles.
"U.S. Treasury bills, notes and bonds and U.S. savings bonds are an excellent, risk-free way to preserve capital, get a pretty good return and keep your investment liquid.
The government sells Treasury securities -- bills, notes and bonds and savings bonds. They are debt instruments sold to raise money to operate the government and pay off debt. Treasury securities are a safe investment because they're backed by the U.S. government."
The 1st Bond Misconception
Not so fast.
This very entry from a household financial site is actually way off base with it's basic description of Treasury Securities.
First and foremost, there is absolutely nothing on Earth that you can invest in that is a risk free proposition. In this instance, it is true that these investments are extremely safe since they are backed by the full faith of the U.S government, however, even the U.S. government isn't infallible. Just recently, the U.S. debt was downgraded by several ratings agencies, which has not happened in recent history. Odds are that everything will be fine, but this is just an illustration that nothing is certain in the investment world....except for taxes.
The Second and most Important Bond Misconception
Second, and the absolutely most important thing to take away from this entry, is that bonds are not a safe investment by any stretch. Bonds fluctuate just like any other security, and the swings in the par value (Basically the price at which a bond could be sold) can be dramatic, resulting in massive investment losses. This is typically the case when interest rates begin to rise, making new bond issues more desirable, due to the fact that they are paying a greater yield. Since new bonds pay more interest, the old bond issues become less desirable, and the par value can drop swiftly.
Example:
If you purchased a 10 year bond paying 3%, the par (price at which it can be sold in the open market) is $1000. Therefore, you would receive a yield of 3% or $30 per year off of this investment.
However, if a year from now, the government is issuing 10 year bonds paying 4%, the bond paying 3% drops in value since the new bond pays $40 a year instead of $30. In essence, the old bond is worth less than the new bond since it doesn't pay as much interest, and the actual value has dropped proportionally.
So, if you owned a bond mutual fund, or had to sell your current bond for some reason, you would not be able to get your $1000 back. You may only be able to get $800 for this bond, resulting in a loss of 20%. This type of loss would be considered extremely bad for equities, and goes to illustrate how you can loose quite a bit of money by investing in bonds.
So why do People Claim that Bonds Are Risk-Free?
This belief is due to the fact that bonds have a maturity date, which means that at a decided time in the future, the bond holder will be reimbursed for the full amount of the bond they originally purchased. So, in the example above, both the 3% bondholder, and the 4% bond holder would be paid back $1000 after 10 years. So, if you are able to hold the bond for the whole period, odds are that you would not lose any money, per se. However, the intangible is that you would earn a lesser amount of interest over the 10 year period.
So, be very careful when investing in bonds, as the losses can be substantial indeed......especially for a investment considered by many to be "risk-free"
