In light of money market funds not achieving any notable returns, many investors have turned to short-term bond funds as a means to increase the return on the portion of savings they wish to keep safe. However, investors should be aware that short-term bond funds carry a higher degree of risk and cannot always be used as an alternative to money market funds.
Short-Term Bond Funds
Short-term bond funds typically invest in bonds that mature within a period ranging from one to three years. The limited time until maturity means that interest rate risk – or the risk that rising interest rates will lead to a decrease in the fund’s principal value – is lower compared to medium- and long-term bond funds. However, even the more conservative short-term bond funds will experience a small degree of price volatility.
Risk Differences
Since short-term bond funds are considered less risky, many investors use these funds as an alternative that offers a higher return compared to money market funds. Money market funds are the lowest-risk option on the risk-and-return scale in fixed income, while short-term bond funds are generally seen as the next step up in terms of risk and return potential.
Choosing Between the Two Types
Although short-term bond funds carry low risk concerning interest rates, they may carry other types of risks depending on the securities they hold in their portfolios. Many funds invest in high-quality corporate bonds or mortgage-backed securities, but this is not always the case. Investors learned this the hard way during the 2008 financial crisis when many funds that placed significant amounts of money into mortgage-related securities experienced severe declines in their share prices.
Short-term does not necessarily mean low risk, so it is crucial to read the materials provided by the issuing company very carefully to ensure that the managers haven’t loaded the portfolio with complex international investments or low-quality corporate bonds. These are the types of securities that can burst if the investment environment deteriorates. Since the Federal Reserve has not raised interest rates for a long time, it is easy to forget that short-term bonds will typically see a decline in share values during periods when the Fed raises interest rates. The declines will be modest compared to other types of funds, but money market funds will not see any decline at all.
Short-term bond funds can offer the advantage of good returns compared to money market funds – ranging from 0.5% to 2% depending on the underlying investments – and this can compound over time. As a result, many investors who are in a position to take on the additional risk of short-term bonds may allocate a portion of their portfolios to this asset class instead of money market funds. If you need to use the funds within a year or have a very low risk tolerance, money market funds are the better option.
Ultra-Short Bond Funds
Investors have an increasing number of options within the realm of ultra-short bond funds. These funds typically invest in bonds that mature within a period ranging from six months to one year. This represents an average maturity longer than that of money market funds, which typically focus on debt that matures within a week or less, and short-term bond funds that mature between one and three years.
How to
Short-Term Bond Investing
For investors looking to allocate a portion of their portfolios to short-term bonds, there are numerous options to choose from. In addition to mutual funds such as the Vanguard Short-Term Bond Fund (VBIRX), T. Rowe Price Short-Term Bond Fund (PRWBX), and Lord Abbett Short Duration Income Fund Class A (LALDX), there is a growing number of exchange-traded funds (ETFs) that focus on this sector. Many short-term bond mutual funds offer check-writing privileges, similar to money market funds, while ETF funds do not offer this feature. However, using short-term bond funds for check-writing is discouraged, as it can lead to significant tax problems. Among the largest ETFs that invest in short-term bonds are:
- Vanguard Short-Term Bond ETF (BSV)
- iShares 1-3 Year Treasury Bond ETF (SHY)
- Vanguard Short-Term Treasury ETF (VGSH)
- Schwab Short-Term U.S. Treasury ETF (SCHO)
- SPDR Portfolio Short Term Corporate Bond ETF (SPSB)
- SPDR Portfolio Short Term Treasury ETF (SPTS)
- SPDR Barclays Capital Investment Grade Floating Rate ETF (FLRN)
- Invesco BulletShares 2022 Corporate Bond ETF (BSCM)
- WisdomTree Bloomberg Floating Rate Treasury Fund (USFR)
- Invesco BulletShares 2023 Corporate Bond ETF (BSCN)
Frequently Asked Questions
What are short-term government bonds?
Government bonds specifically refer to bonds issued by governments rather than corporate entities. The term “government bonds” technically can refer to any level of government, but people may assume you mean the federal government, as state and local government bonds are typically referred to as “municipal bonds.”
Why do short-term bond prices fluctuate?
In short, bond prices are affected by market forces. Many bond investors have a primary focus on interest rates, as they have a significant impact on the demand for bonds. When interest rates rise, investors can earn more interest by purchasing new bonds, and they will be unwilling to pay the same price for an old bond that offers lower interest payments. They will have to provide a deal by lowering the bond price. This also works in the opposite direction; when interest rates fall, individuals trying to sell old bonds with higher interest payments can fetch a higher price than they initially paid.
Why are long-term bonds more sensitive to interest rates than short-term bonds?
Changes in interest rates affect bond payments, and short-term bonds do not have many payments remaining. A slight change in interest rates over a year or two will have little impact on the income of a bondholder. However, if the bond has 30 years of payments remaining, slight changes in interest rates can lead to substantial gains or losses.
Why are money market rates so low?
Compared to other fixed-income products, money market rates are the lowest because they are the safest. If you choose higher-yielding fixed-income options instead, you are taking on additional risks with your core investment. In a broader context, interest rate environments reflect economic conditions. Many factors influence interest rates, but generally speaking, low-rate environments may reflect struggling economies and inflation, while high-rate environments may reflect thriving economies with high inflation.
Source: https://www.thebalancemoney.com/short-term-bonds-funds-vs-money-market-funds-416961
Leave a Reply