In terms of safety, what's the next best thing after government bonds?

Question

For long-term investments (10+ years, or for retirement purposes, even 30+ years), what is the closest thing to government bonds that is almost as safe as them but with greater return?

The problem with government bonds in Europe/US is obvious. Although they are safe, the return, even in the long term, is as close to 0% as you can get. For long-term investments, even the compound interest won't amount to much.

Is there an alternative that would generate reliable interests above 1% and let the investor sleep at night?

Answer 1

Did you go to college? Call up Donor Relations and ask them how they manage their Endowments.

An endowment is a large gift of money, in which the money is invested, and then the college takes out small amounts every year to sustain the organization. The law requires prudent investment of that endowment in such a way that it assured to last forever despite annual withdrawals to support the Endowment's purpose (e.g. funding a science professorship chair, funding a sports program, etc.)

Ask for great detail in how the investments are made. Ask why they invest the endowment as they do.

Then fact-check everything they tell you. Find out how other institutions invest their endowments. Read about the UPMIFA law (Uniform Prudent Management of Institutional Funds Act), and why it is an improvement on UMIFA (same but without "Prudent").

What does this mean to you?

An Endowment is a "forever fund" and is invested for guaranteed growth on a very long time scale. Once you're beyond about 25 years of target horizon, you want to maximize long-term growth, and you will be in the market so long that short-term volatility won't matter. That makes things rather simple.

A young person's IRA or 401K has the same basic objective as the endowment - maximize growth for a time very far in the future. And so, a young person would do well to invest pretty much just like the endowment.

But I don't advise doing that blindly; hence, I recommend schooling up on how endowments work and why.

Volatility is that thing you're spooked by

When you talk about "safe", what you're really talking about is the market's ordinary ups and downs. The word for that is volatility, and it's what gets on the evening news. But just like the Laws of Large Numbers cause randomness to average out, likewise a long time averages out volatility. Did the market go sharply up or down on September 14, 1997? I couldn't care less. From 1990 to 2020 it grew phenomenally. And that's what we're in it for when we're investing an IRA.

Likewise, in 2055, when you are settling down in retirement and you're starting to withdraw from that IRA... do you even care if the market tanked 30% in October 2020? No. All you care is the market grew by a factor of 20 in those 35 years.

We don't give a damn about volatility when the investment is very long-term.

Growth and volatility are a matched set. Investments with the highest long-term growth also suffer the highest short-term volatility. Nature of the beast. Do we care? Nope :)

Now, volatility on an individual-stock basis The key is diversification: Don't own too much of any one stock. The preferred approach is own a tiny bit of a vast array of stocks, such as in an Index Fund.

There's nothing safe about "safe"

Normally, a university draws an endowment down by 4-7% a year, because the market consistently beats inflation by that much, over long-term averages. But now imagine if the university invested their endowment in 1.5% Muni bonds. If they drew down 5% a year, within 20 years the fund would be busted. That's no safe haven, it's the road to perdition! That's not prudent, so they can't do it. To be prudent, they would need to back their drawdown to about 1% a year -- taking 80% less money. Even then, the fund would lose pace with inflation and they would be forced to reduce it to 0.5% or even 0%. This defeats the endowment's purpose. So that's no safe haven either.

For an endowment, the only safety is in the market.

For a young person's 401K, the same is really true, except there isn't a university Board of Directors nor an Attorney General to bring down the wrath if you mess up.

Why we don't do it for short-term funds

Some years back, I gave a large endowment to an organization that they could invest forever, OR buy land. They invested it in Certificates of Deposit. Now before you /facepalm... their sense was that they wanted to buy land in the next year or two. If they had put it in the market, and the market had an abrupt 30% downturn (as can happen)... then next year they'd be buying land with a 30% smaller piggy-bank, which would be terrible! Because their investment was short-term, the "safe" CDs were the right answer.

Indeed, a well-invested 401K slowly phases out of the market and into "safer" investments as you approach the time when you'll start drawing from the 401K. That way you too don't get slammed by a vicious market downturn just as you're about to withdraw the money. This is phased over very slowly, a few percent a year, because you will be drawing the money down for quite a number of years, after all. Some mutual funds do this automatically; these are called "Target Funds" such as a "Target 2055" fund which is set up to be withdrawn starting in 2055.

Answer 2

High quality corporate bonds would generally be next in line. AAA corporate bonds are yielding a bit over 1.5% at the moment.

Of course, if you are holding a bond (corporate or government) and interest rates rise, the value of your bond will decrease. If you are holding an individual bond, you're free to hold it until maturity to ensure that your principal is safe (though worth less because of inflation). If you are holding a bond fund (far more common for individual investors), the fund may end up selling bonds before maturity and realize some losses in order to move the capital to higher yielding bonds. If that causes you to lose sleep at night, you need to be aware of that.

Answer 3

A savings account can get around a 1% return if you go the right bank. It's not a huge return but it is pretty safe.

A money market account could potentially earn a better return and offers advantages like check writing but requires a minimum investment. Certificates of Deposit (CDs) are another option but the rates aren't what they were in the 80s.

Municipal bonds can offer a decent return and typically offer some tax advantages that make them more attractive than treasury bonds.

Real estate can offer returns equal to the stock market and are generally safe since the land is tangible and finite. The prices can vary wildly though based on location and the market.

Stocks offer the best return and the prices generally move inversely to interest rates (ie when interest rates are down stocks go up). However they can be risky especially in this market. Exchange-traded funds (ETFs) and real estate investment trusts (REITs) are options that provide a decent return but offer some protection from market swings.

The answer to the question though is to diversify. Diversification allows you to maintain a decent return while reducing your risk.

Answer 4

Government bonds return "as close to 0% as you can get" because the market perceives them to be the "safest" investments.

Companies and governments issue bonds to raise capital. Of course, buyers want the highest return. But the issuing companies and governments want to raise capital with the lowest cost, which means they want the lowest return for the buyers. As such, bonds are issued with the lowest possible yield that will attract sufficient buyers. If the market believes a particular bond has a low risk of default (the issuer runs out of money and can't repay the bond), more investors will be attracted to it, so the yield doesn't need to be as high.

When a stable government issues a bond, that's generally regarded as the lowest possible risk of default since the government can raise taxes to cover the debt. As such, these bonds will have the lowest possible yields, at least as long as the market trusts the government to pay its debts.

This isn't a "problem": it's a logical consequence of market forces. If you want higher returns, you must accept higher risk. Or, know something the market does not.

For further reading, research "efficient frontier" and "risk-adjusted return".