When we think about risk-free investments, government bonds usually come to mind first. While bonds can be issued by any level of governments – national, regional, municipal and also by supra-national bodies, the term government bonds generally applies only to those issued by national governments.

But we -have to realize that when we hear risk-free, this only applies to one type of risk, namely, credit risk. National governments, especially in the developed countries, generally have higher credit ratings than corporations and are very unlikely to default on their debt obligations. However, other types of risks are still present should not be ignored. Inflation risk is not something many investors worry about, but it is a major factor that needs to be taken into consideration when evaluating government bonds as a possible investment choice.

As a “risk-free” investment vehicle, government bonds usually pay the lowest interest of all investments. Especially because this return comes in a form of 100% taxable interest, the net after-tax return if often below inflation. This means that when you invest your money in government bonds, you may have less money on the inflation adjusted basis that you had a year ago.

Therefore, government bonds are traditionally used only for short term investments, or as a temporary harbor for the money while the investor is figuring out what to do next. Government bonds are also good for corporate investors which are required to keep a certain amount of funds in highly liquid and easily accessible assets, like insurance companies and banks.

Many mutual funds hold government bonds as a safety cushion. Another important type of risk associated with government bonds is currency risk. For example, US government bonds are considered to be one of the safest investment vehicles in the world. But consider a situation when a Canadian investor buys US government bonds during a time of an economic boom when commodity exports increase which pushes the Canadian dollar up. For example, between 2003 and 2005 the US dollar has lost almost 20% of its value and in Canadian dollars that supposedly risk-free investment actually decreased in value. As you can see, there are risks involved even with “risk-free” investments.

Nikolay Sisan is a Certified Financial Planner and freelance writer in Vancouver.