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

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

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.

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