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.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.