What are the risks of government bonds?
You might hear investors say that a government bond is a risk-free investment. Since a government can always print more money to meet its debts, the theory goes, you’ll always get your money back when the bond matures.
In reality, the picture is more complicated. Firstly, governments aren’t always able to produce more capital. And even when they can, it doesn’t prevent them from defaulting on loan payments. But aside from credit risk, there are a few other potential pitfalls to watch out for with government bonds: including risk from interest rates, inflation and currencies.
What is interest rate risk?
Interest rate risk is the potential that rising interest rates will cause the value of your bond to fall. This is because of the effect that high rates have on the opportunity cost of holding a bond when you could get a better return elsewhere.
What is inflation risk?
Inflation risk is the potential that rising inflation will cause the value of your bond to fall. If the rate of inflation rises above the coupon rate of your bond, then your investment will lose you money in real terms. Index-linked bonds are less exposed to inflation risk.
What is currency risk?
Currency risk only applies if you buy a government bond that pays out in a currency that is different to your reference currency. In this case, fluctuating exchange rates may cause the value of your investment to drop.
Government bonds are guaranteed by the full faith and backing of their respective governments. It’s important to note, however, that even government bonds are subject to numerous risks, including credit risk.