Short-Term Bond Funds

While bond funds are often lumped together as a monolithic group in investment literature, there are in fact a wide variety of funds that can help investors meet a broad range of objectives. One of the most important goals of many bond-fund shareholders is the safety of their principal.

If you count yourself among those who need to prioritize capital preservation, short-term bond funds may be right for you. Keep in mind, however, that these funds are unlikely to offer much in the way of yield.

Definition of a Short-Term Bond Fund

A short-term bond fund is a fund that invests in bonds with maturities of less than five years. Any entity can issue short-term debt, including governments, corporations, and companies rated below investment grade.

Risk and Yield

Short-term bonds in this category tend to have lower interest rate risk than either intermediate- or long-term bonds, so they tend to hold up better when market conditions are unfavorable. Regardless of the low risk, it is possible to lose your principal in a short-term bond fund.

For example, in the second quarter of 2013, the bond market performed very poorly. During that time, Vanguard Short-Term Bond (BSV) exchange-traded fund (ETF) fell -0.78%. Even with this fall, it vastly outperformed the -4.02% return of Vanguard Intermediate-Term Bond ETF (BIV) and the -6.07% return of Vanguard Long-Term Bond ETF (BLV). 

Therefore, while short-term bonds fell, their losses were mild compared to other maturity segments. However, short-term bond funds don’t participate in the bond-market upside (growth in value) to the same extent as long-term funds.

Note that not all short-term bond funds are created equal. Some funds invest in securities with higher credit risk, such as high-yield bonds, while others may seek to offset the low-yield environment by venturing into higher-risk securities. Before buying a fund, be sure to check its recent daily fluctuations relative to its peers. If it exhibits above-average volatility, that’s an indication that it may not offer the safety typically associated with short-term bond funds.

Another consideration is that these funds, by virtue of their location on the lower-risk end of the risk-to-return spectrum, offer low yields. Note that risk and yield typically go hand-in-hand in the bond market. In many cases, the yields may not be sufficient to overcome the impact of inflation. However, low yields are the price investors pay for achieving a greater degree of safety.

Short-Term Bond Funds vs. Money Market Funds

Short-term bonds are typically considered to be the next rung up the risk ladder from money market funds. Whereas short-term bond funds have modest share price fluctuation, money market funds can maintain a stable $1 share price.

In exchange for the slightly higher risk, short-term bond funds offer higher yields than money market funds. For this reason, short-term funds can be an option for those with a slightly longer investment horizon (the amount of time an investment is expected to be held), such as two to three years, that allows them to take on a modest degree of risk in exchange for a higher yield.

Reasons to Consider Short-Term Bond Funds

Short-term bond funds aren’t going to make anyone rich. However, they can serve several purposes:

• Bond funds can act as an alternative to the various options that currently offer low yields.
• They can be used as a place to store cash that won’t be needed for another two to three years.
• Short-term bond funds allow investors who are concerned about a possible bear market in bonds to stay invested in the bond market at a lower degree of risk.
• They have a strong historical record of providing a better ratio of return in exchange for the attendant risks of long-term bonds.
• They are less sensitive to rising inflation than intermediate- and long-term bonds.
• Bond funds are highly liquid, which means they offer investors easier access to their capital.

How to Invest in Short-Term Bond Funds

Investors have countless options in the short-term bond fund category. In addition to bond funds, investors can also purchase short-term bond ETFs. Investment brokers are generally where investors go to purchase short-term bond funds.