For example, with Canada Savings Bonds, inflation would erode the purchasing power of the bond as well as the interest. You also have to look at the real rate of return on your money after tax and inflation is factored in. If you were earning 10 per cent interest and were taxed at 35 per cent, your net return would be 6.5 per cent. If inflation were seven per cent, you would actually be losing purchasing power with your money, in real terms.
Deflation risk
If there is a severe or prolonged economic downturn or recession, the value of your assets could drop accordingly.
Interest rate risk
Interest rates in Canada and the United States have been very volatile over the past 15 to 20 years on any type of interest-sensitive financial investment. In the early 1980s the prime rate was in the double digits, even up to 22 per cent. This was of course attractive for people with interest income from term deposits, mortgages, or bonds. By the mid-1990s however, rates had plunged to the low single digits, sometimes down to two per cent. Interest rate risk can cut both ways, however. For example, if you set your lifestyle needs based on high interest rate returns, your lifestyle will be negatively affected when rates fall. Or if you lock yourself into a fixed-rate bond when rates are low and then interest rates increase, the value of the bond investment will go down when you try to sell it. Another example is a locked-in annuity bought at a low interest rate. If rates go up and there is inflation along with it, your purchasing power and lifestyle will be affected.
Government policy risk
The Canadian and U.S. governments are constantly changing the tax or pension laws, depending on the political philosophy of the party in power and economic pressures. For example, Old Age Security (OAS) pension payments are lowered if the recipient’s income exceeds a certain amount. This amount could become lower and lower over time. The Guaranteed Income Supplement (GIS) could be reduced, or the eligibility criteria tightened up. Federal and/or provincial income taxes could be increased. Canada has proposed a new Senior’s Benefit Program to be implemented in 2001, which will affect both income and taxes.
Repayment risk
This type of risk comes in several forms. One form of risk is not being repaid what you are owed when it is due or when you want your money. For example, if you buy a bond, the issuer’s ability to repay you determines whether you are going to get your money back. Although bonds issued by municipalities, corporations, or governments rarely default, several levels of credit risk are normally involved. Agencies such as Standard & Poor, Moody’s Investors Service, and Dominion Bond Rating Service rate the credit risk of various bonds, which generally range from “AAA” to “D”. These ratings indicate the repayment risk you are taking with a particular bond issue.
Insurance companies are also rated by different agencies, including one in Canada called “TRAC”. Considering that insurance companies go under from time to time, you don’t want to risk losing money you are expecting from insurance proceeds, cash surrender value funds, disability insurance payments, or annuities.
