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The Potential Risks of Short-Term Bond Funds

Got short-term bonds? For a growing number of investors, the answer is “yes.” And that could be a problem in the making.

As reported Dec. 28 by the Wall Street Journal, more short-term bond funds are loading up on riskier securities lately. The 95 short-term bond funds tracked by Morningstar have increased their average exposure to high-yield “junk” bonds – as well as other securities rated below investment grade – to 6.4% of total assets this year from 5.8% in 2009 and 3.7% in 2008.

One warning sign regarding short-term bonds concerns the annual yield and if it is much greater than the category’s average of 2%, according to the WSJ article. Generally, funds yielding more than double that amount are likely to have a higher exposure to lower-grade investments.

During the 2008  financial crisis, several short-term bond funds that had previously been posting good returns but held large positions in bonds with poor credit quality suffered as much as a 25% drop in value as a result of the economic downturn, said Craig McCann, president of the Securities Litigation & Consulting Group, in the Wall Street Journal story.

“The highest-performing funds are also the most risky ones,” McCann said. “It just might not be apparent to investors right away.”

Experts advise investors to do their homework before investing in short-term funds – and that means thoroughly researching a fund’s holdings, investigating the fund’s marketing literature and even reviewing filings with the Securities and Exchange Commission (SEC).

One key piece of information to know concerns the yield and from where it is coming. Like many investments, if it’s too good to be true, it probably is.

Says the WSJ story: “If a fund does have a large position in higher-yielding or lower-rated securities, investors should make sure they know which individual bonds the fund is buying – as well as its total exposure to each type of bond and its rating – before determining whether the risk is manageable.”

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