Investors for whom principal protection is the most important consideration have a wealth of options to consider from among bonds and bond mutual funds. While low risk also equates to low return, many investors – such as retirees and those who need to access their savings for a specific need within one to two years – are more than willing to give up some yield to be able to sleep at night. With that in mind, here are the leading options in the low-risk segment of the fixed income market.
Savings bonds – These are the safest investment there is, since they’re backed by the government, and they’re guaranteed not to lose principal. They don’t offer exceptional yields, but that isn’t the point. If you want to keep your money absolutely safe, savings bonds are the best option. They’re easy to buy through TreasuryDirect, and they’re tax-free on both the state and local levels. In addition, they may also be tax-free on the federal level is used to pay for education. The one drawback is that they aren’t as liquid as some other types of investments – you can’t cash them in within the first year of their life, and if you have to cash them in within the first five year you will pay a three-month interest penalty.
Treasury bills – Treasury bills (or “T-bills”) are short-term bonds that mature within one year or less from their time of issuance. T-bills are sold with maturities of four, 13, 26, and 52 weeks, which are more commonly referred to as the one-, three-, six-, and 12-month T-bills, respectively. Since the maturities on Treasury bills are so short, they typically offer lower yields than those available on Treasury notes or bonds. However, their short maturities also mean that they have no risk: investors don’t have to worry about the U.S. government defaulting in the next year, and the interval is so short that changes in prevailing interest rates don’t come into play. T-bills are also easily bought and sold via TreasuryDirect.
Banking instruments – Certificates of deposit and bank savings accounts are among the safest options you will find in the fixed income universe, but with two caveats. One, be sure the institution where you hold your money is FDIC-insured, and two, make sure your total account is below the FDIC insurance maximum. Neither of these investments will make you rich, but they will give you the peace of mind that comes with knowing that your cash will be there when you need it.
U.S. Treasury notes and bonds – Despite the fiscal travails of the U.S. governments, longer-term Treasury securities are still entirely safe if they are held until maturity in the sense that investors are guaranteed to get their principal back. Prior to maturity, however, their prices can fluctuate substantially. As a result, investors for whom safety is a priority need to be sure that they won’t need to cash in their holdings prior to their maturity dates. Also, keep in mind that a mutual fund or exchange-traded fund that invests in Treasuries does not mature, and therefore carries with it the risk of principal loss.
Stable value funds – Stable value funds, an investment option in retirement plan programs (such as 401(k)s) and certain other tax-deferred vehicles, offer guaranteed return of principal with higher returns than are typically available in money market funds. Stable value funds are insurance products, since a bank or insurance company guarantees the return of principal and interest. The funds invest in high-quality fixed-income securities with maturities averaging about three years, which is how they can generate their higher yield. The benefits of stable value funds are principal preservation, liquidity, stability and steady growth in principal and returned interest, and returns similar to intermediate-term bond funds but with the liquidity and certainty of money market funds. Keep in mind though, this option is limited to tax-deferred accounts.
Money market funds – rising rates are higher-yielding alternatives to bank accounts. While not government-insured, they are regulated by the Securities and Exchange Commission (SEC). Money market funds invest in short-term securities – such as Treasury bills or short-term commercial paper – that are liquid enough (i.e., traded in sufficient volume) that managers can meet the need for shareholder redemptions with little difficulty. Money market funds seek to maintain a $1 share price, but the possibility exists that they could fail to meet this goal – an event known as “breaking the buck” This is a very rare occurrence, so money market funds are seen as being one of the safest investments. At the same time, however, they are typically among the lowest-yielding options.
Short-term bond funds – Short-term bond funds typically invest in bonds that mature in one to three years. The limited amount of time until maturity means that interest rate risk – or the risk that rising interest rates will cause the value of the fund’s principal value to decline – is low compared to intermediate-term bond funds (those that invest in bonds with maturities of three to ten years) and long-term bond funds (ten years and up). Still, even the most conservative short-term bonds funds will still have a small degree of share price fluctuation.
High-rated bonds – Many debt securities carry credit ratings, which enable investors to determine the strength of the issuer’s financial condition. Bonds with the highest credit ratings are extremely unlikely to default, so that is almost never an issue for high-rated bonds and the funds that invest in them. However, as with Treasury notes, even high-rated bonds are at risk of short-term principal loss if interest rates rise. Again, this isn’t an issue if you plan to hold an individual bond until maturity, but if you sell a bond prior to its maturity date – or if you own a mutual fund or ETF that focuses on higher-rated bonds, you are still taking on the risk of principal loss no matter how highly rated the investments.
Naturally, investors don’t need to choose just one of these categories. Diversifying among two or more market segments may actually be preferable, since you avoid “putting all of your eggs into one basket.” However, the most important thing to keep in mind is that under no circumstance should you try to earn extra yield by putting money into investments that have more risk than is appropriate for your objectives.
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. Always talk to a financial and tax advisor before you invest.