Currently, one of the drawbacks to money market funds is a nearly nonexistent rate of return. In order to increase the returns on their investments, many investors are turning to short-term bond funds as a solution. Short-term bond funds, due to their higher rate of risk, are not a replacement for money market funds, but can be an excellent supplement and alternative option for investors.
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Short-term bond funds normally invest in bonds that reach maturity in between one and three years. This rapid maturation involves a very low interest rate risk compared to intermediate-term or long-term bond funds—it is highly unlikely that rising interests rates will decrease the value of the short-term bond fund’s initial cost, also known as principal. However, as with any bond, some share price fluctuation is to be anticipated.
In comparison to money market funds, short-term bonds are higher risk but carry a better potential for return on investment. Generally, money market funds are considered to be the safest investment with the lowest returns, with short-term bond funds considered slightly riskier with a similarly increased potential for higher yields.
For many investors, short-term bond funds are a stronger option that money market funds, but it is important to take a number of factors into consideration when deciding which type of fund to purchase. Although money market funds are a lower-risk option, they have a lower return potential. Short-term bond funds have a low interest rate risk, but can carry other types of risk based on the securities in their portfolios. For example, although many funds invest in typically safe mortgage-backed securities and high-quality corporate bonds, circumstances can cause this security to vary. The 2008 financial crisis caused dramatic drops in the share prices of many funds that were mortgage-related. This ordinarily safe security became a significant liability for shareholders. Incidents such as the 2008 crisis are examples of why short-term securities are not without risk.
In order to protect themselves, investors should always read any listing material very carefully. Additionally, investors should ensure that the portfolio of the fund that they are considering does not have complex international investments or low-quality corporate bonds—these securities are highly sensitive and reactive to the investment climate, and are the most likely culprits of significant losses.
Another factor to take into consideration is federal interest rates. When the Federal Reserve raises rates, short-term bond prices often experience a reactionary share price drop. Although these price drops will be less dramatic than the share price decreases of other types of funds, money market fund accounts will not experience any decline. Investors debating money market fund investments versus short-term bond fund investments would be well-advised to take this into consideration when making decisions.
If an investor is willing to take on the risk of a short-term bond fund, the yields of the bond funds are higher than those of money market funds by between one half of a percent and two percent. They tend to be best for those investors who can accommodate some degree of risk in their portfolios—investors unwilling to take on risk would be advised to choose money market funds instead. Also, investors who, other than those who cannot take on risk, may need to use their money immediately should opt for money market funds instead of short-term bond funds.
In summary, short-term bond funds carry a slightly higher degree of risk along with a higher rate of return than mutual funds. For investors who do not require immediate access to their money and whose portfolios are able to accommodate some risk, short-term bond funds can be a wise investment. For those investors who would prefer security and are willing to accept lower returns, money market funds are a preferable solution.
About Lawrence Meyers
Larry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at firstname.lastname@example.org.Want to learn how to generate more income from your portfolio so you can live better? Get our free guide to income investing here.