What are the risks of investing in Treasury bonds?

It's common for financial analysts and investment publications to refer to U.S. Treasury bonds (T-bonds) as risk-free investments. This designation is basically true while at the same time misleading. Thanks to the implicit backing of all Treasury Department obligations by the Federal Reserve, there is virtually no risk of principal loss on a T-bond.

Most credit relationships, from mortgage loans to corporate bonds, carry default risk. The lender assumes the risk of the borrower failing to meet principal or interest payment obligations. Even in cases where bankruptcy proceedings can help recover creditor funds, there are no real guarantees in the market.

This isn't true with T-bonds, because the Federal Reserve can always act as a backstop for the federal government. Investors know that the Treasury Department will always pay them back, even when the Fed's balance sheet is ugly.

Even though the risk of default is almost non-existent, T-bond investing risk is centered around opportunity costs, interest rate fluctuations and rising prices.

If the Federal Reserve creates too much new credit, the economy runs the risk of experiencing inflation. The principal amount on a normal T-bond is only guaranteed in nominal amounts. In an inflationary environment, the return on principal is worth less than the initial investment. This issue is compounded by the traditionally low yields on Treasuries.

Treasuries also carry interest rate risk, meaning when interest rates rise, the market value of debt obligations tends to drop. This makes it difficult for the bond investor to liquidate without losing on the investment.

All financial decisions, even T-bond investments, carry opportunity costs. When an investor purchases a $1,000 T-bond, he loses the ability to spend that $1,000 on other things. Perhaps the investor would have been better off purchasing a different type of security with a higher return, or buying consumer goods that he ends up valuing more highly than the yield on the bonds.