Every investment has risk. And don’t let the U.S. government tell you otherwise.
Most investors come across the term “risk-free” early in their investment education. It refers to an asset you can invest in, not worry about and be assured a certain return, without losing any money. The standard for risk-free assets is a U.S. Treasury bill, or T-bill.
T-bills are considered the safest investments in the world. They are short-term loans to the U.S. government that the government pays back with interest. The only way to lose any money is if the U.S. government runs out of money. Since the government can print more money or raise taxes when they need more cash, the chances of the U.S. government defaulting on their loans is almost nil.
In fact, three-month T-bills are considered so safe that they are used as a starting point to value other investments. Most stock analysts calculate how much a company is likely to grow over the “risk-free rate” – the three-month T-bill rate – as part of the process of figuring out how much a stock is worth.
But “risk-free” depends on the definition you use for risk.
In general, bonds are considered less risky than stocks, commodities or real estate. If you think of a bond as a loan, there are really just two ways you can lose money – if the entity you lend to won’t, or can’t, pay you back (default risk); or when the money they pay you back is worth less (inflation risk).
Default risk for most countries is low. It doesn’t happen very often, but it does happen. Many countries have done it at some point in their history. Greece and Argentina are two recent sovereign default offenders. They borrowed more than they could later pay back, and lenders were left holding nearly worthless bonds, and other countries and organizations had to come their rescue.
There is only a handful of countries that have never defaulted on their debt, including Canada, England, Malaysia and Singapore. The U.S. has never technically defaulted, but it has come close over the course of its history. Most recently, in 2011 credit ratings agency Standard & Poor’s downgraded the U.S. credit rating (its credit score) from AAA (the highest rating) to AA+ (one level down, but still excellent), after political games pushed the U.S. close to defaulting. In other words, S&P are saying that the debt of one of the richest countries in the world is now slightly riskier – and no longer “risk free”.
But the greatest risk to T-bills comes from inflation, which is the increase in prices over time. Inflation reduces how much you can buy with the same amount of money. You may save a $100 for a year, but if things cost more at the end of the year, your $100 is now worth less — you can no longer afford something that cost a $100 last year.
The “real rate of return” is used to adjust investment returns for inflation. A positive real rate of return means the investment earned more than the inflation rate, while a negative real return means the investment earned less than the inflation rate.
This is a common risk for low-yield investments like T-bills, because when inflation is higher than the interest you earn on the T-bill, you get a negative real rate of return. That means your investment has actually lost value, after you adjust for inflation.
Take, for example, a T-bill bought today and held for a year. Currently, a 12-month T-bill yields around 0.5%. U.S. inflation for the 12 months ending November 2015 was 0.50%. There’s no way to say for sure how high inflation will be next year. But if we assume it’s 0.75%, we’d actually see a real rate of return of negative 0.25%. So if you lent the U.S. government $100, you’d get back $100.50 but the actual buying power of that $100.50 would be about $99.75, due to inflation.
So investing in T-bills right now will likely yield very little or no real return. And that’s assuming inflation is accurately reported. Governments are often accused of under-reporting actual inflation. A higher inflation rate would result in a lower real rate of return.
The chances are extremely low that the U.S. government would ever default on a loan, especially a T-bill. But just because you don’t lose money, it doesn’t mean you have a positive return. The real risk is that the money you get back won’t buy as much as when you originally lent it. And that’s the biggest risk “risk free” T-bills face. So the notion of risk free… is just a dangerous idea.