Bond duration is a double-edged sword. Companies that issue bonds repay their debts over 10, 20 or even 30 years. For investors bond coupons generate limited but steady returns for years. They also lock up money. Short term bond funds solve that problem by maturing in less than a year. Here’s how they work.
What Are Short Term Bonds?
As noted, short term bonds are debt instruments issued by companies and governments that mature in less than five years but more than 365 days.
Short term bonds are considered low-risk, low-volatility instruments. By paying off in just a few years, they leave a very limited window for default or loss. They also return the investor’s money fairly quickly, limiting the opportunity cost of investment.
Because of this, short term bonds are often considered cash-equivalent investments. You can liquidate them easily and can plan to use the money again in the near future.
Short Term Bond Funds and Risk
One of the most important issues with bond investment is inflation and interest. Long term bonds can create very real risks on both of these issues, and they are a significant part of the attraction for short term bonds.
Interest Rate Risk
All bonds carry what is known as “interest rate risk.” This is the risk that interest rates will rise over the lifetime of the bond, saddling you with a bond that underperforms relative to the rest of the market. For example, say you buy a 20 year bond paying 3%. Over the coming year the Federal Reserve raises interest rates by 0.75%. Now the new bonds coming onto the market might pay 3.75%.
You’re earning less than you could. More importantly, most investors buy bonds intending to trade them on the secondary market rather than keep the money locked up for years on end. Now you will have to sell your bond in an environment where investors could just as easily buy one paying 0.75 points more. This almost always means taking a loss on the face value of the bond just to get any money out of it at all.
The returns on a bond fluctuate relative to inflation. As inflation grows, the bond’s effective rate of return decreases. For example, say you buy that 20 year bond paying 3% interest. Suppose also that inflation is at 2%. This means that the spending power of your money decreases by 2% per year, creating an effective yield on this bond of 1%.
If inflation declines while you hold the bond, it will get effectively more valuable. If it goes up, your yield will decline. This creates a form of risk that investors cannot control.
Short term bond funds minimize both of these risks. Holding bonds that matures in just a few years means less opportunity for interest rates and inflation to fluctuate unpredictably. This makes them valuable to investors who want to know what will happen with their money.
Short Term Bonds: Pros
The main reasons for investing in a short term bond fund include:
- Inflation/Interest Rate Risk: Short term bond funds minimize the systemic risk that comes from inflation and interest rate fluctuations. They are low volatility instruments because their shorterbond durations minimize the opportunities for unpredictable events.
- Liquidity: Short term bond funds are highly liquid. Their low volatility and near-term bond maturity rates mean that investors get their money back quickly, which also makes them relatively easy to sell.
- Limited Default Risk: The brief duration of short term bond funds limits credit risk. There are fewer opportunities for the borrower to default, creating a more reliable instrument.
Short Term Bonds: Cons
The main reason not to invest in short term bond funds is limited returns.
Short term bond funds provide a combination of high liquidity and high security. That makes them very marketable. So organizations don’t have to pay very much in order to sell them.
Short term bond funds pay less, often far less, than long term bonds. For example, at time of writing a six month Treasury instrument paid 1.55% interest, while 30 year bonds paid 2.21%. Two randomly selected Vanguard short term bond funds yielded a return of 1.68% for the short term assets and 3.05% for the long term ones.
Short Term Bonds Compared
The main difference between short term bond funds and long term bonds is stability and liquidity. For a retail investor, this will often not make a significant difference. If your priority is risk mitigation, well rated long term bonds (generally purchased through a mutual fund or ETF) will give you a better rate of return at a degree of risk that will work for almost any individual investor.
Short Term Bonds vs. Cash
However sometimes the liquidity can be a very real asset. This is particularly true when it comes to cash reserves.
You never want to completely tie up your access to cash. Sometimes unexpected expenses crop up and you simply need access to an emergency fund. Still, short term bonds can often provide a better alternative for money you want to keep close at hand. They provide a stronger rate of return than a savings account and are typically easy to liquidate. Except for short term spending money, short term bonds can be a strong alternative to keeping cash reserves in the bank.
Short Term Bonds vs. Stocks
Short term bonds are an asymmetrical alternative to equities.
Most investors buy stocks for their growth. The section of your portfolio with equities, either in the form of individual stocks or funds, will generally post the strongest returns out of all your investments. Short term bonds can’t offer that.
The Bottom Line
Like stocks short term bonds are highly liquid, but they serve a different role. For retail investors they are usually best used as a way to keep money liquid and secure, but to get a better rate of return than the bank can offer. They cannot offer the growth potential of stocks.
- If you aren’t sure how bonds fit into your investment picture, you may want to consult a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, start now.
- What are bonds? How do you apply them to your portfolio? These are fundamental questions, and answering them can help you step up to the next level of investing potential. If you’re interested in bonds but not sure how to find them, it can be fairly easy once you know where to look. Finally, you may want to learn more about the many types of bonds on the market so that you can pick the ones perfectly tailored to your portfolio.
Photo credit: ©iStock.com/Jitalia17, ©iStock.com/skynesher, ©iStock.com/guvendemir