Short-Term Bonds Funds, More Yield Without Taking on Much Risk

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Short-Term Bonds Funds, More Yield Without Taking on Much Risk
Short-Term Bonds Funds, More Yield Without Taking on Much Risk

When you shop for an investment, look for short-term funds with steady records. Top performers have long records for making money every year. Plenty of savers are frustrated with the puny yields available on the safest investments.

Money market funds yield 0.08%, while one-year bank certificates of deposit yield about 1.0%. To get better results, consider short-term bond funds, which yield 2.6%. During the past three years, short-term funds have delivered annual total returns of 3.8%, a solid result in a period when stocks have been in the red.  

Short-term funds invest in bonds with maturities of one to five years. Make no mistake, bonds come with risks. While bank CDs are guaranteed against losses, bond funds can blow up. When markets crashed in 2008, the average short-term fund lost 4.2%. The big losses occurred because of the turmoil of the credit crisis. But short-term funds could suffer minor losses in more normal times. Like all bonds, short-term securities tend to sink when interest rates rise. During such periods, investors often sell veteran bonds with low yields, pushing down the prices.

Still, short-term bonds funds represent an intriguing option, a way to get a bit more yield without taking on much risk. To appreciate the appeal of short-term funds, compare them to their siblings, intermediate and long-term bond funds. Long-term funds currently yield 5.0% and invest in bonds with maturities of 10 years or more, while intermediate funds yield 3.9% and typically specialize in maturities of five to ten years.

Investors who crave extra yield may favor long-term funds. But before you write a check, keep in mind that the higher the yields, the more the risk. If rates rise by one percentage point, the average long fund would lose 10%. Intermediate-term funds would drop 4.4%, and short-term bonds would lose 1.8%.

Steady results long-term

Intermediate- and long-term bonds can drop sharply as investors sell quickly to avoid being locked for years in low-yielding investments. But most of the bond funds would eventually recover, as portfolio managers reinvest income in higher-yielding securities. Besides suffering the smallest losses, short-term bonds should bounce back the fastest. Over the long-term, short-term funds should deliver relatively steady results while outperforming money markets by a wide margin.

Will the funds suffer losses soon? Probably not. Most economists think that the Federal Reserve will keep rates low until at least 2012. After that, rates could rise slowly. 

No matter what direction rates take, it always pays to diversify. So many investors should hold a mix of short-, intermediate-, and long-term bonds. But these days it makes sense to stabilize portfolios by holding a big stake in low-risk short-term funds.

When shopping for an investment, look for short-term funds with steady records. Top performers have long records for making money every year, including 2008. Keep in mind that the funds hold a variety of different securities, including Treasuries, corporate bonds, and mortgage-backed securities issued by government agencies such as Fannie Mae. Some funds have a conservative bent, emphasizing government bonds, whereas other funds take on more risk, owning lower-quality corporate issues and mortgage securities that are not backed by government agencies.

Bond options

Conservative investors should consider T. Rowe Price Short-Term Bond, which has returned 4.7% annually during the past ten years, outperforming 70% of its competitors. The fund yields 2.8%. Portfolio manager Ted Wiese emphasizes a mix of high-quality corporate securities and mortgages. He has shown a knack for steering away from dicey selections. In 2008, Wiese avoided shaky subprime mortgages and emphasized government-backed issues. That enabled the fund to stay in the black.

These days Wiese is emphasizing corporate bonds instead of government issues. With investors seeking safety, prices of government-backed securities have climbed. When bond prices rise, the yields fall. Now, yields on government securities are skimpy. In comparison, corporate bonds pay more tempting yields. The T. Rowe Price fund has 50% of his assets in investment-grade corporate bonds, up from 28% two years ago.

An issuer that Wiese likes is SLM, commonly known as Sallie Mae, which makes education loans. The two-year securities yield 5.5%. The bonds are attractive compared with two-year Treasuries, which yield 0.35%. Wiese concedes that Sallie Mae faces some problems. The company is struggling to maintain its market share, but Wiese argues that the company remains on solid ground. “Sallie Mae has the ability to borrow, so there is not much risk that it will run out of funds,” he says.

Investors who can tolerate a bit more risk should consider Weitz Short-Intermediate Income, which returned 5.5% annually during the past decade, outdoing 93% of peers. The fund currently yields 2.5%. Weitz proved resilient in the downturn of 2008, returning 2.3% for the year.

Portfolio manager Thomas Carney aims to emphasize the most appealing areas of the fixed-income universe. When corporate bonds look cheap, he overweights the sector. When the fund can't find bargains, Carney will hold low-yielding cash while he waits for more tempting holdings to appear.

The fund currently has 20% of assets in cash. Carney is shunning some government securities because the yields are tiny. Instead, he is shopping for unloved corporate issues. He favors bonds from Expedia, the online travel company. The recession hurt travel demand. But as the economy recovers, Expedia is increasing sales and taking market share away from competitors.

Another fund that has stayed in the black is Delaware Limited-Term Diversified Income, which returned 5.4% annually during the past decade, outdoing 92% of competitors. As the credit crisis worsened, Delaware sold shakier corporate bonds and bought rock-solid Treasuries. That enabled the fund to return 2.2% in 2008.

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