What are the Investments with Low Risk? Financial instruments with a small risk are bonds and mutual funds which invest in bonds. Small Risk of Loss in an Investment? Market risk exists with interest rate fluctuations and potential income usually exceeds the level of inflation by 2 to 4 %. The duration of these investments span from 1 to 40 years. The fees range from 1% for bonds to 5 0.5% for mutual funds. As a general rule, the bigger an investment, the smaller the fee. The minimum investments range from $2,000 (mutual fund) to $25,000 (bonds).
Bonds are issued by the U.S. government and corporations. They bring their owners stable and fixed income in the form of a coupon. Buying a bond means lending money to a corporation. No ownership rights are received. As a lender, fixed income is guaranteed until the loan matures (is paid off). Bond maturities vary from 1 – 40 years.
The advantage of buying a bond is relatively high income comparison to savings accounts. U.S. government bonds are considered to be the safest. The income usually exceeds the level of inflation by 4 – 5 %. Corporate bonds vary from a safety point of view, and usually pay income 1 – 4 % more than government bonds at one time.
The issuers of bonds usually pay income twice a year. Even though the income is fixed, the price of the bond fluctuates inversely with the price of interest rates. The decline of interest rates causes the price of the bond to go up and vice a versa.
Since bond prices fluctuate, an investor may make or lose money selling a bond before maturity. The face value of one bond is usually $1,000, but in practice it is difficult to purchase less than 25 bonds at one time.
Tax free municipal bonds are issued by the state and local governments and their agencies. Tax free bonds are favored by investors in high income tax brackets.
• An advantage of these obligations is that the income is not subject to tax by federal governments, and, in many cases by state and local governments.
• A disadvantage is the market risk which investors must assume. Investors should consult with their financial consultants before making a purchase.
• Tax free bonds usually yield the same income as savings accounts. The face value of one bond is usually $5,000, but it is difficult to buy less than 5 bonds, or $25,000.
Unit Investment Trusts (UITs)
UlTs are created by Investment Banking firms which typically buy a portfolio of bonds with a fixed maturity and then resell them as units to individual investors. UITs are most commonly used to buy tax free bonds.
• The advantage of UITs is the diversification of funds (pools typically consist of 25 – 30 bonds) and relatively small capital requirements. The investors receive income monthly from the pool and as individual bonds mature, return of capital is provided.
• The disadvantage is a relatively high fee (2 – 5.5%). In addition investors typically must pay the liquidation fee of up to 3.5%. To avoid the liquidation costs the investor should think about UITs as longer term investments (5-15 years).
Zero Coupon Bonds
Zero coupon bonds pay no interest (the way the traditional bonds do), but grow in value over a period of years. An investment of $350, for instance, promises to return $1,000 in ten years. The profit is $650 (which is the difference between the cost and the redemption price). Zeros lock infixed rates of return. Since there are no semi-annual interest payments to reinvest at future interest rates, the exact yield is known over the life of the bond.
Though zeros don’t pay cash interest, the Internal Revenue Service taxes them as if they did. (Tax-exempt municipal zeros being an exception.) That is why zeros are best suited for tax-deferred accounts such as IRAs or Keoghs, or for custodial accounts in the names of young children in low tax brackets.
Since there is no money paid until maturity, an entire investment may be lost if the issuer defaults before that time. For this reason, the most popular zeros are based on U.S. Treasury obligations, which are the safest securities. Also, prices of zeros tend to be volatile. Typically, market values of long-term zeros go up and down twice as quickly as those for coupon-paying bonds. This is not a problem if zeros are held to maturity, but money can be lost if they are sold before the maturity date.
Mortgage Backed Securities (MBS)
Mortgage-backed securities have become increasingly popular with investors seeking steady income. Most actively traded are Ginnie Mae (Government National Mortgage Association) certificates, which represent a share in a pool of government-guaranteed mortgages and, unlike many other federal agency obligations, are backed by the full faith and credit of the U.S. government. A Ginnie Mae investor receives both interest and a partial return of capital each month, representing partial repayments of principal on all mortgages in the pool.
Although mortgages typically run for 25 to 30 years, Ginnie Mae yields are projected to have an average life of 12 years. Sometimes mortgages are prepaid and the life of the pool is shortened, increasing the yield.
• The advantage of mortgage backed securities is 1% to 2% higher income in comparison with government bonds.
• The disadvantage is mortgage prepayment by borrowers forcing investers to reinvest at possibly lower rates.
• Minimum investment in original Ginnie Mae certificates is about $25,000, although existing certificates can sometimes be purchased for less. Ginnie Maes can also be purchased through one of the many Ginnie Mae trusts and funds, with a minimum investment of about $1,000.
Is small Risk of Loss in an Investment possible? Of course, all mentioned financial instruments are the examples. Among low risk investments one should mention also Preferred Stock that include straight, cumulative, convertible, callable and participating. They are described here or here.