As low-risk, quickie investment vehicles go, short-term bond funds are worth a second look. Short-term bond funds are a type of mutual fund. They invest in fixed-income securities that mature in four years or so, such as certificates of deposit and corporate bonds. For risk-averse investors, short-term bond funds may offer a means to earn a little extra cheddar while bypassing the negative effects that fluctuating interest rates often have on longer-term investments. However, short-term bond funds are not immune to interest rate risk, and they can lose money just like any other investment. Other common pitfalls associated with short-term bond funds include credit risk and prepayment risk.
Yield and Liquidity
Yield-wise, short-term bond funds tend to be pretty attractive, particularly when compared to money market funds. They also are highly liquid vehicles, meaning investors can access the funds without having to jump through administrative hoops, and some even let investors write checks on them. But (yes, there is a “but”), investors need to keep in mind that short-term bond funds are pooled funds, so the liquidity needs of other investors will affect yields. For example, if the number of investors pulling money out of the fund tops those socking money away in it, the fund managers may need to sell some of the bonds in the fund to boost overall cash flow, even if it means selling them at a loss.
In general, interest rates affect short-term bond funds to a lesser extent than bonds with long-term maturities. That said, almost all bond funds are susceptible to fluctuating interest rates. Market value -- what investors are willing to pay for the bond -- rises and falls toe to toe with interest rates, and that’s just how it is. If interest rates rise, the market value of the fund’s bond holdings will drop.
If the issuer of a bond in a short-term bond fund defaults, this is known as credit risk, and it means the bond holders don’t get paid. Failure to repay the debt owed to bond holders on the part of the bond issuer can occur for several reasons, including the downgrading of the issuer’s creditworthiness by a credit rating agency such as Moody’s, Standard & Poor’s or Fitch. Credit risk tends to be less of an issue for government bonds.
In a prepayment risk scenario, the party that issued the bond pays it out at an inopportune time -- when interest rates are low, for example. This means the fund managers have to reinvest those earnings in bonds with less-than-optimal interest rates, which drives down the overall return of the fund. The good news is that not all bonds are created equal: Some can’t be prepaid.
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