Short-term bond funds fit the niche for investors looking for a little more yield than CDs and money market funds with a high degree of safety. Picking a short-term bond fund involves a little more research than just selecting the highest yield and mailing in a check. There are risks involved with these funds -- risks that a prudent fund choice can minimize.
The term of an investment bond can range from 30 days to 30 years. In most interest-rate environments, longer-term bonds have higher yield. The trade-off involves both higher price volatility and the lockup of investor money for those longer terms. Short-term bonds mature in less than three years. The portfolio of a short-term bond fund will have an average maturity of two to three years.
Types of Bonds
There are different sectors of the bond market, and a short-term bond fund may hold bonds from just one or several of the sectors. Types of bonds include government bonds, corporate bonds -- both investment grade and high-yield, mortgage-backed securities -- and municipal bonds. A municipal bond short-term fund will invest only in municipal bonds to provide a tax-free income to investors. The Web pages of a taxable bond fund will show a breakdown of the types of bonds owned by the fund. Non-investment grade or high-yield bonds are from issuers with lower credit ratings -- and these bonds have a higher probability of default.
A short-term bond fund is not an entirely risk-free substitute for savings products like bank CDs. The major risk with bonds comes from falling bond prices if interest rates increase. A bond fund will publish its current portfolio duration, which is similar to average maturity but the result of a different math calculation and will be shorter than the fund's average maturity. The duration is the percentage the share price of a fund will change if interest rates change by 1 percent. A short-term bond fund will typically have a duration in the range of two to 2.5 years.
Making an Investment Choice
Don't select a short-term bond fund based strictly on the current distribution yield. The focus of this type of investment should be the safety of principal, so review the credit quality of a fund's portfolio and the current duration. A safe investment choice would be a fund holding a majority of investment grade bonds, a duration close to 2 years and a low expense ratio. If you're in a high tax bracket, consider a short-term municipal bond fund.
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