Why Short-Term Bond Products Can Be a Good Bet

Now that money market yields of 3% have become a fact of life, many investors are seeking larger payouts. But many also are reluctant to buy long-term bonds, despite some experts’ advice that today’s yields are worth the risk of locking up your money.

Those uncertain investors can make a compromise move by switching into short-term bond funds.

These hybrid investments occupy an important niche on the risk-reward spectrum, halfway between money market funds and regular bond portfolios.

The short-term funds, which generally hold domestic bonds coming due in one to three years, seek a sufficiently lucrative but not-too-volatile middle ground. Yields tend to increase on fixed-income securities having more distant maturity dates, but so does exposure to interest rate risk.

To a large degree, the short-term funds have succeeded as compromise investments. Over the five years through August, they returned a respectable 8.8% a year on average, according to Lipper Analytical Services in Summit, N.J.

That figure includes the impact of capital gains, as well as interest income or yield.

At the same time, they’ve been remarkably consistent for avoiding losses. Many of these funds have never suffered a down year, and a few have never had an off quarter.

Most short-term bond portfolios debuted in the middle and late 1980s.

What makes the funds so stable is their near-term holdings. For every 1% increase in interest rates, the bonds they hold will fall by only 2%, estimates the Vanguard Group, a fund family in Valley Forge, Pa.

By contrast, a fund holding 10-year bonds would drop about 7% for the same uptick in interest rates, and a portfolio of 20-year bonds would slump 9%.

Money market funds don’t suffer any principal changes, but their yields fluctuate more dramatically. At the moment, taxable money funds pay only about 3%. That compares with 5.1% on average for the short-term bond portfolios, according to Lipper.

It’s worth emphasizing that the short-term bond funds don’t carry any guarantees against loss. As noted, rising interest rates will hurt these investments, offsetting part of the yield.

“A 1% rise in rates puts you back to where you would have been in a money market fund,” says Brian Mattes, a Vanguard vice president.

“If you need the money in a year or less and can’t accept any losses, a short-term bond fund might not be suitable,” he says.

In absolute terms, the funds’ near-term outlook appears mediocre. Those 8.8% annual gains for the last five years came during a period of generally higher yields and falling interest rates. With current yields of 5.1 or so, that’s the approximate overall return you can expect in the absence of further rate cuts.

On the other hand, that still beats both money fund yields and inflation by two percentage points.

“Over time, you can expect to get reasonably good protection from inflation” with the short-term funds, says Paul W. Boltz, chief economist at T. Rowe Price Associates, a Baltimore-based fund company.

If you’re considering a short-term bond fund for the first time, here are some further points to keep in mind:

* Don’t assume that these funds will mature. Unlike individual bonds or certificates of deposit, very few bond mutual funds liquidate or come due on a specific future date. As portfolio holdings mature, they’re replaced with new investments.

With short-term bond funds, the “short” part of the name refers only to the type of debt held--government or corporate IOUs maturing in one to three years, possibly as far out as five years.

Of course, you can sell out of a short-term bond fund whenever you want, often with no charge.

* Pay attention to default risk. Individual bonds are evaluated for creditworthiness. Ratings range from AAA on down, with bonds graded BB and below defining the “junk” market. Lower-rated bonds yield more but also carry a greater risk of default.

When shopping around, find out which credit ratings each fund holds, and in what amounts.

Compare apples to apples. Fund companies tout various types of yields, each calculated a bit differently. When making comparisons, focus on the SEC-standardized yield, which all firms must compute following the same assumptions and procedures.

“This is the best way to compare apples to apples,” says Mattes. “It puts all the funds on the same playing field.”

Lipper also uses the SEC yield when calculating group averages. In brief, the short-term bond funds aren’t the types of investments you will ever make a killing on. If interest rates stay flat or decline further, longer-term portfolios make more sense. If rates rise sharply, money funds are the place to be.

But if you don’t know where rates are headed and simply don’t want to assume much risk, the short-term portfolios offer a compromise solution, especially if you’re easing into bond investments for the first time.

“The big advantage is that you don’t lose much principal when rates go up,” says Boltz. “And you beat money markets when rates are flat or go down.”

Some of the Best The following short-term bond funds set the standard for solid investment returns and low risk.

All have gained at least 8% annually on average over the past five years. None has lost more than 1% in any quarter over that span, and a few have never had a down quarter.

The total returns cited below include both interest income and any capital gains or losses. These funds are available to smaller investors through selected discount brokers and/or investment advisers only.

Average annual Sales Fund Name return charge Telephone Delaware Treasury Reserves Intermediate +8.77% 3% (800) 523-4640 DFA One-Year Fixed Income +8.28% None (310) 395-8005 Federated Intermediate Government +9.28% None (800) 245-5000 Federated Short-Intermediate Government +8.32% None (800) 245-5000 Fidelity Short-Term Bond +8.71% None (800) 544-8888 Neuberger & Berman Limited Maturity Bond +8.85% None (800) 877-9700 PIMCO Low Duration +10.21% None (800) 927-4648 T. Rowe Price Short-Term Bond +8.29% None (800) 638-5660 Smith Barney Income Return +8.60% 1.5% (800) 544-7835 Vanguard Fixed-Income, Short-Term Corporate +9.49% None (800) 662-7447

Source: Morningstar Mutual Funds of Chicago

For five-year period ending June 30