At a time when money market funds are yielding virtually nothing, many investors have looked to short-term bond funds as a way to boost the yield on the portion of their savings they want to keep safe. However, investors need to be aware that short-term bond funds carry a higher degree of risk and cannot always be used as a money market fund substitute.
Short-Term Bond Funds
Short-term bond funds typically invest in bonds that mature in one to three years. The limited amount of time until maturity means that interest rate risk—or the risk that rising interest rates will cause the value of the fund’s principal value to decline—is low compared to intermediate- and long-term bond funds. Still, even the most conservative short-term bonds funds will have a small degree of share price fluctuation.
Since short-term bond funds tend to be lower risk, many investors use the funds as a higher-yielding alternative to money market funds. Money market funds are the lowest risk option on the fixed income risk-reward spectrum, and short-term bond funds are generally considered to be the next step up the ladder in terms of both risks and return potential.
Choosing Between the Two
While short-term bond funds have low interest rate risk, they can have other types of risk depending on the securities they hold in their portfolios. Many funds invest in high-quality corporate bonds or mortgage-backed securities, but this isn’t always the case. Investors learned this the hard way during the financial crisis of 2008 when many funds that had put too much money in mortgage-related securities experienced huge drops in their share prices.
Short-term doesn’t necessarily mean low risk, so read the material from the issuing company very carefully to make sure the managers haven’t loaded up the portfolio with complicated international investments or low-quality corporate bonds. These are the types of securities that can blow up if the investment environment sours. Since the Federal Reserve hasn't raised interest rates in a while, it’s easy to forget that short-term bonds will typically experience share price declines during the periods when the Fed is raising rates. The declines will be modest in comparison to other types of funds, but money market funds won't experience any downside at all.
Short-term bond funds can offer a decent yield advantage relative to money market funds—anywhere from 0.5%–2%, depending on their underlying investments—and this can add up over time. As a result, many investors who are in a position to take on the added risk of short-term bonds can allocate a portion of their portfolios to the asset class instead of money market funds. If you need to use the money within a year or have an extremely low tolerance for risk, money market funds are the better option.
Ultrashort Bond Funds
Investors have a growing number of options within the universe of ultrashort bond funds. The funds typically invest in bonds with maturities of between six months and one year. This represents a longer average maturity than money market funds, which typically focus on debts with maturities of a week or less, and short-term bond funds, where maturities tend to run between one and three years.
How to Invest in Short-Term Bonds
Investors who want to allocate some of their portfolios to short-term bonds have several options to choose from. In addition to mutual funds such as Vanguard Short-Term Bond Index Fund Admiral Shares (VBIRX), T. Rowe Price Short-Term Bond Fund (PRWBX), and Lord Abbett Short Duration Income Fund Class A (LALDX), there are a growing number of exchange-traded funds (ETFs) that focus on the sector. Many short-term bond mutual funds offer check-writing privileges, as money market funds do, while ETFs do not. However, it is not recommended that investors use short-term bond funds for check writing, because it creates a significant tax headache. 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 (FAQs)
What are short-term government bonds?
Government bonds refer specifically to bonds issued by governments rather than corporate entities. Talking about "government bonds" could technically refer to any level of government, but people may assume that you mean the federal government, since state- and local-level government bonds are typically called "municipal bonds."
Why do short-term bond prices go up and down?
In short, bond prices are moved by market forces. Many bond investors are primarily concerned with interest rates, because they have a significant impact on the demand for bonds. When interest rates go up, investors can get paid more interest by buying new bonds, and they won't want to pay the same price for an older bond that is offering lower interest payments. Anyone who tries to sell old bonds with lower interest payments will have to offer a deal by cutting the price of the bond. This also works the other way around; when interest rates go down, people who try to sell older bonds with higher interest payments will be able to charge a higher price than they initially paid.
Why are longer-term bonds more sensitive to interest rates than short-term bonds?
Changes to interest rates affect bond payments, and short-term bonds don't have as many payments left to make. A small change to interest rates for a year or two won't have as much of an impact on a bondholder's income. However, if that bond still has 30 years of payments left, then small interest rate changes could add up to significant 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 instead choose fixed-income options with higher interest rates, then you are taking on additional risk to your principal investment. In a broader sense, interest rate environments reflect economic conditions. Many factors impact interest rates, but as a general rule of thumb, low-rate environments may reflect struggling and deflationary economies, while high-rate environments may reflect booming economies with high inflation.