Where Short Bonds Can Help Your Portfolio

by Dan Wiener | April 3, 2012 10:00 am

There are times when short-term bond funds make sense as a substitute for money markets.  This is true when you’ve got cash sitting around that you don’t need right away and are willing to take just a smidgen of risk with. The idea is to earn a better return without taking on too much additional risk of capital loss. I have always been a big proponent of this strategy—long before money market yields hit bottom. But it’s important to enter this position with eyes wide open to both the risks and potential returns from such a strategy.

Let’s start with the risk, because I always feel that if you can’t live with the risks, you shouldn’t reach for extra potential returns. When I suggest a short-term bond fund over a money market, I’m not aiming to take on lots of risk. The credit market freeze in 2008 put all types of funds, short-term bond and money markets included, to the test. The original money market fund, the Reserve Fund, broke the buck on Sept. 16, 2008. But with the crisis behind us, we know that Vanguard’s funds have been battle-tested and all survived to fight another day.

For investors in one of the tax-free money funds like Tax-Exempt Money Market, I recommend extending out to a fund like Short-Term Tax-Exempt, which I liken to a money fund on steroids. I have used this one myself. Going back more than 15 years, the worst 3-month loss for the fund was just
0.5%, as the table below indicates. That’s something I can live with.

For taxable investors in a fund like Prime Money Market or one of the government leaning funds like Federal Money Market, I’ve always recommended Short-Term Investment-Grade. That advice proved to be terrific until the credit crisis of 2008, when Short-Term Investment-Grade suffered huge short-term losses as credit markets locked up.

Before the credit crisis, the worst 3-monthloss in the fund was about 2.2%. During the crisis however, Short-Term Investment-Grade lost 6.8% in three months. Though that loss was recovered quickly, for some investors those few months would have been harrowing. While any of Vanguard’s other short-term funds would have proven a safer bet, this is a stellar example of why I recommended earlier that, for short-term spending needs, there is no substitute for cash.

Even so, I still think Short-Term Investment- Grade is a good alternative for cash, particularly in the current low interest-rate environment. I’ve done a  rolling returns analysis listing the worst three-month, six-month and 12-month returns over the past 18 years, as well as the best and average returns over those periods.  Short-Term Investment-Grade’s “worst” is pretty bad. But its “best” returns are also pretty darned good. That said, I completely understand if you want something a bit calmer. On average, you wouldn’t go wrong with any of Vanguard’s short-term funds, in my opinion.

There’s one other alternative for what I’ll call “longer-term” cash that you may find of interest. Many years ago, Paul Kaplan, former manager of iShares Barclay’s GNMA (NASDAQ:GNMA[1]) as well as Wellesley Income’s bond portfolio and the now-retired chief of Wellington Management’s bond shop, told me that he considered GNMA a cash “substitute.” The data backs him up, though GNMA is still a bit riskier than most short-term funds. It’s really up to you how much (potential) short-term pain you’re willing to suffer for the prospect of longer-term gains.

Have no doubts, interest rates will rise again. Money markets will produce some income again. As I laid out in detail last month, I have serious concerns about trying to increase income and return by extending duration too far in today’s low interest-rate environment.

However, my analysis showed that short maturity bonds can still perform well in a rising rate environment. While there is no free lunch, I expect it will continue to pay to take a tiny bit of risk with cash you can afford to hold on to for months, and extend your “cash maturities” to a short-term bond fund for the potentially higher overall return.

  1. GNMA: http://studio-5.financialcontent.com/investplace/quote?Symbol=GNMA

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