Question

Which one of the following earned the highest risk premium over the period 1926-2013?

Multiple Choice

• U.S. Treasury bills

• Long-term government bonds

• Small-company stocks

• Long-term corporate bonds

• Large-company stocks

Answer 1

U.S. Treasury bills

Reason :

Financial analysts and the financial media often refer to U.S. Treasury bonds (T-bonds) as risk-free investments. And it's true. The United States government has never defaulted on a debt or missed a payment on a debt. You would have to envision the utter collapse of the government to find a scenario that would involve losing any of the principal invested in a T-bond.

Most investments in debt, from corporate bonds to mortgage-backed securities, carry some degree of default risk. The investor accepts the risk that the borrower will be unable to keep up the interest payments or return the principal invested.

In the event of bankruptcy, bondholders are first in line before other investors, but that's no guarantee of full repayment.

This is not true for T-bonds, which are backed by "the full faith and credit" of the U.S. government. That means the Federal Reserve. Investors know that the Treasury Department will pay them back even if the Fed's balance sheet is ugly.

So, the risks to investing in T-bonds are opportunity risks. That is, the investor might have gotten a better return elsewhere, and only time will tell. The dangers lie in three areas: inflation, interest rate risk, and opportunity costs.

Inflation

Every economy experiences inflation from time to time, to one degree or another. T-bonds have a low yield, or return on investment. A little bit of inflation can erase that return, and a little more can effectively eat into your savings.

That is, an investment of $1,000 in a T-bond for one year at 1% interest would get you $1,010. But if inflation was 2%, the initial investment when it is returned will have the buying power of a little under $990.

This example uses round numbers for the sake of simplicity. The actual yield of a one-year T-bond as of March 6, 2020, was 1.41%. The annual inflation rate was 2.5%.

Interest Rate Risk

When interest rates rise, the market value of debt securities tends to drop. This makes it difficult for the bond investor to sell a T-bond without losing on the investment.

Opportunity Costs

All financial decisions, even T-bond investments, carry opportunity costs.

An investor who purchases a $1,000 T-bond loses the chance to invest or spend that $1,000 elsewhere. The investor might have been better off putting $1,000 into an exchange-traded fund (ETF) that offered a greater potential for return along with a greater risk of principal loss. For that matter, the investor might have bought a new laptop for $1,000. If inflation continues at its current pace, that model will cost $1,025 a year from now.