Certificates of Deposit (CDs)
CDs are short-term debt instruments often issued by banks to raise money. They are issued for a fixed maturity period and typically have lower risk.
Overnight Funds
These overnight instruments are backed by collateral which comprises of Government Securities, and so these funds also have no credit risk. These are the safest debt funds but their yield is usually also the lowest. Overnight funds are suitable for parking your funds for a few days.
Compared to stocks and more volatile assets, bonds are generally considered a lower-risk investment option. There are different types of bonds with varying degrees of risk. Government Bonds issued by the federal government are seen as the safest as they are backed by the full faith and credit of the government.
Treasurys are generally considered "risk-free" since the federal government guarantees them and has never (yet) defaulted. These government bonds are often best for investors seeking a safe haven for their money, particularly during volatile market periods. They offer high liquidity due to an active secondary market.
Understanding Investment Risks
Among the options provided, U.S. government securities represent the category with the lowest risk. This is due to several key factors: Government bonds are backed by the full faith and credit of the U.S. government, making them virtually risk-free regarding default.
Credit Ratings and High Yield Debt
Bonds with AAA rating are the most secure, with the lowest probability of default, whereas bonds with D rating are the least secure, with the highest probability of default.
Common types of secured debt for consumers are mortgages and auto loans, in which the item being financed becomes the collateral for the financing. With a car loan, if the borrower fails to make timely payments, then the loan issuer can eventually acquire ownership of the vehicle.
Because Treasuries are backed by the "full faith and credit" of the U.S. government, they're considered one of the safest investments.
Junk Bonds
Junk bonds are high-yield corporate bonds issued by companies with lower credit ratings. Because of their higher risk of default, they offer higher interest rates, potentially providing returns over 10%. During economic growth periods, the risk of default decreases, making junk bonds particularly attractive.
Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.
Bonds are the most common debt instrument. Bonds are created through a contract known as a bond indenture. They are fixed-income securities that are contractually obligated to provide a series of interest payments of a fixed amount and also repayment of the principal amount at maturity.
For example, if the current Risk-Free Rate is 4%, and the company's Interest Coverage Ratio (EBITDA / Interest or a close variation) is between 2.00x and 2.50x, its credit default spread is approximately 2%. Therefore, its Cost of Debt based on this method is 4% + 2% = 6%, and we could use this in the WACC formula.
If a secured debt defaults, the lender can take the collateral. That's why secured debts are generally viewed as having a lower risk for lenders than unsecured debts.
High-interest loans -- which could include payday loans or unsecured personal loans -- can be considered bad debt, as the high interest payments can be difficult for the borrower to pay back, often putting them in a worse financial situation.
Good debt is money you borrow for something that has the potential to increase in value or expand your potential income. For example, a mortgage may help you buy a home that can appreciate in value. Student loans may increase your future income by helping you get the job you've wanted.
The investment type that typically carries the least risk is a savings account. CDs, bonds, and money market accounts could be grouped in as the least risky investment types around. These financial instruments have minimal market exposure, which means they're less affected by fluctuations than stocks or funds.
If you're looking for the safest place to keep your money, look no further than a savings account. Your money will be insured by the FDIC, and you'll have access to it at any time via an online transfer or a debit/ATM card, depending on the policies of your bank.
TAKEAWAYS: Not losing money by holding a bond until maturity is an illusion. The economic impact of market rate changes still impacts investors holding bonds until maturity. A bond index fund provides an investor with greater diversification and less risk.