Plenty of investors have been shifting cash from money-market funds into short-term bond funds. The move is producing some immediate rewards. At a time when money-market funds yield almost nothing, short-term funds yield 1.8%, according to Morningstar.
But new shareholders may not appreciate the risks of short-term bond funds. While money-market funds almost never suffer losses, short-term funds can blow up. During the turmoil of 2008, the average short-term fund lost 4.2%. Of the 125 short-term funds tracked by Morningstar, a dozen suffered double-digit losses, with several declining more than 30%.
The big losses can be traced to the extreme conditions of the credit crisis. But short-term funds can sink in more settled times. Like all bonds, short-term securities tend to decline when interest rates rise. Short-term funds have an average duration of about two years. The duration indicates that if interest rates rise by 1%, fund share prices could drop about 2%. Such a move could easily occur in coming years when the Federal Reserve finally raises rates.
Despite the risks, conservative short-term funds can be sound choices. Top funds have long records for making money every year -- including 2008. When interest rates rise, short bonds tend to fall less than intermediate bonds. So short-term funds can be ideal choices for investors who want low-risk fixed-income vehicles. Despite their relative safety, short-term funds can gain almost as much as intermediate funds. During the past decade, short-term funds returned 4.2% annually, while intermediate funds returned 5.8%.
Conservative investors should consider
T. Rowe Price Short-Term Bond
, which has returned 4.7% annually during the past decade, outdoing 70% of its peers. Portfolio manager Ted Wiese emphasizes a mix of high-quality mortgages and corporate securities. He overweights cheaper sectors and steers away from dicey selections. In 2008, he avoided subprime mortgages and emphasized government-backed mortgages. 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. Wiese has 50% of his assets in investment-grade corporate bonds, up from 28% two years ago.
A favorite issuer is
, 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 0.46%. 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 secure sources of funding, and there is not much risk that the company will run into trouble," he says.
Investors who can tolerate a bit more risk may prefer
Weitz Short-Intermediate Income
, which returned 5.5% annually during the past decade, outdoing 93% of peers. In 2008, the fund returned 2.3%. Portfolio manager Thomas Carney roams widely in search of undervalued securities. He sometimes owns high-yield securities, which are rated below investment grade. When Carney can't find any bargains, he will hold cash. "We are willing to wait until we find attractive opportunities," Carney says.
The fund currently has 20% of assets in cash. Carney is avoiding many high-quality securities because the yields are tiny. Instead, he is shopping for unloved corporate issues. He favors issues from
, the online travel company. The ratings agencies take a mixed view of the company, with one agency awarding an investment-grade rating and another considering the company to be below investment grade. Because some institutions cannot buy low-quality issues, the bonds are undervalued, Carney says.
Another solid fund that can hold some lower-quality issues is
Delaware Limited-Term Diversified Income
, which returned 5.4% annually during the past decade, outdoing 92% of competitors. As the credit crisis unfolded, the fund shifted away from high-yield bonds and held some rock-solid Treasuries. Then as markets began to hit bottom, the portfolio managers scooped up depressed corporate bonds. Good timing enabled the fund to outperform most competitors during the decline of 2008 and last year's rebound.
This year the fund has lowered its allocation to high-yield bonds, but it still has 10% of assets in the sector. "Early in 2009, we could find lots of high-yield bonds to buy because they were priced for the worst case," portfolio manager Roger Early says. "Now the bonds are priced closer to fair value, but we can still find some individual issues to buy."
Throughout the downturn, Early owned issues from some depressed banks, including
. The issues have rebounded, but he continues to hold them. The banks remain solid performers, he says.
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Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.