Do You Know What’s In Your Short-Term Bond Funds? by Leonard Aplet, CFA, Mary Werler, CFA and Catherine Stienstra, ColumbiaManagement

  • High-quality short-term bond funds can provide attractive returns for investors seeking a conservative investment option in today’s uncertain interest rate environment.
  • Not all short-term bond funds are created equal. Some managers take reasonable, well-diversified risks; others may be tempted to chase yield, with the results being risks that may exceed investor tolerance.
  • Know what you own!

Now that the Federal Reserve (the Fed) has ended its Quantitative Easing (QE) program, what is next for interest rates and fixed-income investments?  Many investors expect the Fed to begin raising short rates sometime in 2015. Consequently, they are cautious in their asset allocations, maybe shying away from fixed-income investments. Regardless of the possibility of higher rates, we believe that investors should remain fully invested. At the same time, they should be wary about having too much credit and interest rate risk in their portfolio. In such an environment, short-term bond funds may be worth a closer look. Short-term bond funds can deliver attractive yields and a low level of volatility while investing in high-quality bonds with limited credit/interest rate risk.

Regardless of the investing climate, we believe at least a portion of an investor’s assets should be allocated to lower volatility, liquid investments, whether to meet planned or unexpected expenses. The last thing you want is for your investment to be worth much less than you started with, especially as you are approaching retirement or planning for a major expense like a child’s college education. However, not all short-term bond funds are created equal. Some take on greater risk — interest rate risk and/or credit risk — than others. Given the level of uncertainty on how soon the Fed will act and what the impact will be, it may be prudent to examine your bond portfolio to ensure you understand the risks therein.

In their ongoing search for yield, some investors may have missed how much interest rate risk or credit risk was driving the strong returns of their short-term bond funds. Looking under the hood of your bond fund can help shed light on the amount and kinds of risks the fund is taking. Is the fund earning its yield by investing in riskier below-investment grade bonds, through riskier sectors or longer maturity bonds? Remember, there is no free lunch. Higher yield generally means higher risk.

In this low and uncertain interest rate environment, how can conservative investors stay invested, avoid excess interest rate or credit risk and still generate a competitive return?

A high-quality short-term bond fund can provide an attractive income by investing in high-quality bonds diversified by issuer, industry and geography; the fund should also have limited credit and interest rate risk. Moving out the yield curve from money market instruments, but still within the short duration maturity spectrum, can provide some high-quality bond choices. During periods of rising rates, floating rate securities with short maturities can benefit from having their coupons adjust upwards as yields rise. Floaters can help balance having a better yield while managing interest rate risk. In addition, a barbell approach, which overweights the short end for its liquidity and overweights the longer end of the short space for its higher yield can be beneficial. Being selective about duration and yield curve positioning can help manage the overall interest rate risk. Remember, the composition of a fund’s duration (placement along the maturity spectrum) is just as important as the duration itself.

We believe rotating sectors and being selective about which high-quality bonds to buy tends to add the most value to yield and total return. To diversify credit risk, it is best to keep corporate bond holdings well-diversified, usually owning less than 1% per name, even with high-quality bonds. It is possible to obtain attractive yields without dipping down into non-investment grade bonds. We especially like bonds that couple high credit quality with attractive yields, and historically, the agency mortgage-backed securities market has provided higher than average risk-adjusted returns.

Taxes matter

Keep in mind that many fixed-income strategies come in taxable and tax-exempt options. Investors in higher income tax brackets may want to consider a short-term municipal bond fund. These funds distribute income exempt from federal and/or state taxes, and the tax benefit can be significant. For example, for investors in the 43.4% federal income tax bracket, the 0.81% yield of the Barclays 1-3 Year Muni Bond Index equates to a 1.43% taxable-equivalent yield once the impact of taxes is included.

The end of QE has resulted in heightened market uncertainty. Now is a good time to analyze your short-term bond fund to truly understand its risks, which may not be obvious, and to ensure it can be expected to provide you with the level of income, credit quality, liquidity, volatility, diversification and reliability you need.

The Barclays Municipal 1-3 Year Index is a subset of the Barclays Municipal Bond Index that measures the performance of investment-grade issues with remaining maturities of one to three years.

Income from tax-exempt municipal bonds or municipal bond funds may be subject to state and local taxes, and a portion of income may be subject to the federal and/or state alternative minimum tax for certain investors. Federal income
tax rules will apply to any capital gains.

There are risks associated with an investment in bond investments, including the impact of interest rates, credit, and inflation. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities.

Do You Know What's In Your Short-Term Bond Funds?