Looking back over the past 12 months or so you could call this the “Year of the Treasury.” Not only has our U.S. Treasury been active in the bond markets, but Treasury bonds have been on a tear as investors have flocked to their super-safe government guarantees, ignoring a precipitous decline in yields as they opted for a return of capital versus a return on capital.

As such, there’s seldom been as big a divide between yields on various types of bonds, or bond funds.

My preference is for corporate bonds over Treasurys because, among other things, when inflation does come back, Treasurys will get clipped while corporate bonds will weather that storm a whole lot better.

And, given where yields sit today, an investment in a fund like Short-Term Investment-Grade may prove to be one of the best fixed-income buys you can make. More here.

Obviously inflation is not a big deal today. March’s Producer Price Index and Consumer Price Index reports showed, at best, a benign rise in some inflation components. But for now, I’d say you’re safe worrying about other things and putting inflation on the back-burner for the moment.

Risk and Return in Bond Market Investing

Before talking about Vanguard’s individual bond funds, I find that it’s always helpful to review the risks and returns inherent in bond market investing because investors seem to understand the risks they take in stocks better than those taken in bonds.

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Stock market investors are pretty clear about the tradeoffs between risk and return when they invest, partly because swings in the stock market can be quite broad. The more you put into the stock market, the greater the risk to your overall capital.

Stocks and stock funds are primarily plays on capital. While dividends do have their place, and can account for a significant portion of a stock’s return in some cases, the real mover in the stock market is prices — plain and simple. I should note that currently, the dividend yield on the S&P 500, or the Dow Industrials, is quite good on a relative basis, but not sumptuous on an absolute level.

As long-time GNMA manager Paul Kaplan, now retired, once described it to me, investors who purchase long-maturity bonds, or funds, are reducing their income risk but trading it for capital risk. A long-term bond investor receives a certain level of income month after month because his or her bonds have long maturities and just keep paying out the same income month after month (or every six months, depending on their payment schedule).

But of course there is fairly decent principal risk on a long bond, because over the time you are holding it, the price can move dramatically up or down, depending on how interest rates are changing. And of course, there’s always ample time for the borrower to default entirely.

A short-term bond investor takes lots of income risk but little capital risk. Short-term bonds, by definition, mature fairly quickly and hence their prices can remain fairly stable. Even if they bounce around a lot, the investor knows they will mature relatively soon, and the closer one gets to the maturity date, the lower the volatility and the closer the bond will trade, in price, to par, or its face value.

But because that maturing bond’s principal must be re-invested, the short-term bond investor takes on much more income risk. In a falling interest rate environment, that matured bond’s principal may have to be reinvested at lower rates.

NEXT: Taxable vs. Tax-Exempt Funds

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Taxable vs. Tax-Exempt Funds

One last issue to deal with is taxes — unfortunately. Vanguard has a slew of excellent tax-exempt funds, and it’s really important to review the tax-equivalent yield information in my monthly newsletter’s Performance Review to determine if it makes more sense for you to use a taxable or tax-exempt option.

Just remember that when comparing taxable and tax-exempt funds you should look at funds with comparable maturities (or durations) rather than letting their names guide you. Yes, Intermediate-Term Tax-Exempt can be compared to all the intermediate-term taxable funds, but Short-Term Tax-Exempt is definitely not a substitute for the short-term taxables.

Now, let’s get into some of the specifics of Vanguard taxable fixed-income offerings.

Buy: Short-Term Investment-Grade

Short-Term Investment-Grade is my favorite fund at the short end of the yield curve. That said, its descent last fall certainly tested my claims that the fund is an extremely safe option for those looking to boost yield on large cash reserves.

Because the fund doesn’t invest in government-backed securities, it took a beating when credit markets seized up. But it’s already on the road to recovery and I remain a huge fan. And who can look askance at a yield of 4.58% when the comparable Treasury fund yields just 1.11%?

I use this fund as a higher-yield cash substitute in my Model Portfolios and would recommend it in that role for most any portfolio invested for the long haul.

Of course, because some of the income earned in the government funds is free of state and local taxes, you might come out slightly ahead in those funds if you live in a high-tax state. But if taxes are a big concern you should probably be considering a tax-exempt fund.

NEXT: Buy Short-Term Bond Index

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Buy: Short-Term Bond Index

Short-Term Bond Index tracks the Barclays 1–5 Year Government/Credit Index, which is made up of almost 2,000 investment-grade Treasury, government agency and corporate bonds with maturities of one to five years. So it holds both government and corporate bonds.

The fund, by the way, holds more than 1,000 of these securities as it’s required to put at least 80% of assets into bonds that are specifically part of the index. What it doesn’t own is GNMAs.

Like Intermediate-Term Bond Index, it has a slightly higher duration than the comparable actively managed funds that Vanguard runs. Here, duration is currently about 2.6 years, at the high end of its historical range. Still, risk remains low, as with all the short-term funds.

I own this fund in my Growth Index Model Portfolio for its low risk and reliable performance. That said, indexing the bond market can be tough, and this fund suffered the ignominy of making a couple of really bad calls in 2002, causing it to substantially lag its bogey. Vanguard says it has fixed the problem, and so far it appears they have. I prefer Short-Term Investment-Grade, but I suspect that over time both funds will track more and more closely.

Sell: Long-Term Treasury

Long-term funds are often tempting because of their higher yields, but they come with a price — higher risk. Right now Long-Term Treasury doesn’t even offer such a high yield, and I think risk is huge. Should inflation roar back faster than it has of late, this fund could be hit especially hard.

Generally, the bond market is a wonderfully efficient machine, and every time there’s a sniff of inflation in the air, long-term yields go up and prices go down. Lately, with the government buying bonds to boost the economy, Treasurys have held up. But eventually that source of support is going to end.

With a duration of 11.6 years, this fund exposes investors to more than twice the risk of the intermediate-term funds. And the yield pick-up just isn’t that attractive. I’d rather stay shorter, and safer, than be sorry.