Give me 5 minutes - I'll teach you about short term bond funds
What flavor of bonds do you like? The answer to that question depends on your goals.
Are you focused on owning specific types of bonds like corporates? Are you more focused on safety and look to governments? The key is always to know what your goal(s) are and which bonds may accomplish them.
In this post I am going to talk about short term bond funds. Highlighting key things for you to know when exploring them.
What is a short term bond fund?
By definition a short term bond fund is a mutual fund or ETF that buys and holds bonds that mature in 3 years or less.
They buy securities/bonds from a wide range of issuers. These include corporate debt, government securities, mortgage-backed securities, and other asset-backed securities. Because of the wide range of securities a short term bond fund can buy they are not guaranteed by the FDIC or any other government agency. So, they have a higher risk profile than a US Government T-bill or FDIC backed bank certificate of deposit.
Risk From Interest Rate Changes
Bond and bond fund prices change when interest rates move. Because of this you can lose money in a bond fund. Even a short term bond fund!
When interest rates rise, bond prices go lower. When interest rates fall, bond prices go higher. That is interest rate risk.
Another factor to be aware of is duration. Duration is a measure of how sensitive a bond/bond funds price is to interest rate changes. The higher the number, the faster the price moves.
Short term bond funds are not immune from interest rate and duration risk, especially in today’s super low rate environment. In fact, when markets are moving toward a higher interest rate environment. Your potential to lose money by investing in the fund grows.
Know the Credit Quality of the Holdings
The ability to buy bonds from a wide range of issuers requires you to know the quality of the fund holdings. Each holding inside of the fund plays its role in determining the yield the fund can pay.
This is critical information to you as a buyer. A higher yield generally indicates a higher level of potential risk.
When the bond fund is only purchasing US Government bonds. You can rest easy because people view US Government debt as the safest in the world. When a fund is investing in other issuers. Like corporations, mortgage backed securities, derivatives, etc. You are taking on credit risk.
Credit risk is the potential bond issuers could see a downgrade, default or be subject to negative business factors. That increases the potential for the interest rate to go higher after the security is purchased and for it to go lower in price. In turn this will take the bond fund price lower, resulting in possible principal loss to investors.
Diversification Keeps the Boat Afloat
The previous two sections highlighted the main risks with short term bond funds. Now to a positive.
Bond funds buy hundreds and sometimes thousands of holdings. This lets the fund create a diversified portfolio which is something many individual investors would not be able to create on their own. This is a benefit because if certain bond issuers become a problem, the remaining holdings should keep the fund afloat.
Liquidity is There, Until It Is Not
Parking your cash in something that pays you is usually a smart idea. But what about when you need to get that cash back?
In normal market conditions the process looks like this:
A short term bond fund has thousands of owners. Because of this when you want to get your cash back there is almost always a willing buyer of your shares. This means that when you need your cash. You log on or call your investment broker and execute a trade in the amount of cash you need. The cash will be in your account within 3 days of your sale.
In times of market crisis the smooth example above may not be the case.
During the initial part of the COVID-19 pandemic short term bond funds were on the ropes. Bond prices were crashing lower and it was every investor for themselves. The expected level of liquidity evaporated and even the most battle tested fund manager sat in shock.
Short term bond funds saw over $20 billion in investor funds leave. They were only able to rebound when the Federal Reserve came to the rescue.
Without that government intervention to bring liquidity to the market. One can only imagine the potential principal losses investors may have taken.
Odds and Ends to Consider
Before we wrap up we want to highlight odds and ends to consider about short term bond funds.
A mutual fund company manages a short term bond fund. They charge a fee to handle the work an individual investor does not want to do. Be mindful of what fund managers charge. It can be shocking to see the variation between fund managers. These fees affect your returns.
Short term bond funds can pay dividends and capital gains. Receiving these can alter or subject you to different tax implications. Speak with your tax advisor to make sure you factor these into your tax planning strategy.
If the idea of a short term bond fund interests you. You should also consider a SMA - Separately Managed Account.
An SMA allows you to directly own your cash and investments and not have them commingled with other investors like a mutual fund or ETF.
An SMA also allows you to create a customized portfolio to match YOUR specific and unique needs. You can focus only on issuers and credit ratings you are comfortable with, or maybe the exact maturity ranges you want. The combinations can be endless. The flexibility of a SMA puts the investor in the driver seat of control. Not the fund manager at XYZ mutual fund company.
Short term bond funds are an off the shelf investment vehicle. Mutual funds and ETFs were created for the masses. If you value having control of your funds with customization to YOU. Then an SMA is worth researching.
At InterPrime we only use SMA’s. That’s because each of our clients and their companies are unique. Our goal is to give them total control of their corporate cash. Using an off shelf investment product does not give them that.
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