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Low interest rates have worked wonders for debt-ridden consumers. For those who have cash they need to invest, however, low rates are causing a bunch of problems.

Although stocks have historically given investors the best returns over the long haul, putting money you'll need within the next few years in the stock market exposes you to huge amounts of risk. If your timing's bad, then you could run into the brick wall of a bear market and have to sell at exactly the worst time.

That's why many savers stick with less risky investments for their short-term savings. Yet with many low-risk savings vehicles having seen their income dwindle to almost nothing, some are jumping into alternatives that are riskier than they probably think.

The falling money-market fund
Perhaps the easiest way to set cash aside is through a money-market mutual fund. Currently, investors have a staggering $3.5 trillion set aside in money-market funds.

Yet according to the Wall Street Journal, many savers have fled the safety of money-market funds in search of higher rates. That's not hard to believe, given that top-yielding money market funds are paying out only 0.6%, and most clock in at less than 0.25%. Faced with a paltry $20 per month income on $100,000 in savings, many are making the classic mistake of buying longer-term securities like bond funds at what may prove to be exactly the wrong time.

The troubles of bond funds
Bond funds have two major problems. First and foremost, unlike money-market funds and other similar fixed products like bank CDs, bond funds expose you directly to interest rate risk. If interest rates rise -- which looks like an increasingly likely proposition in the near future -- then bond funds will drop in price. And unlike a bond you own directly, a bond fund doesn't give you the option to get back your full principal at maturity; you could be stuck with that loss.

In addition, the investments that some bond funds make aren't nearly as safe as a bank CD or money-market fund. For instance, take a look at the Vanguard Short-Term Corporate Bond Fund (VFSTX). It has an average maturity of about 2.5 years and currently yields 2.79%. But take a look at some of the companies whose bonds the fund owns:


Value of Bonds Held

Alcoa (NYSE: AA  )

$22.7 million

Bank of America (NYSE: BAC  )

$228.1 million

Citigroup (NYSE: C  )

$261.1 million

MGM Mirage (NYSE: MGM  )

$10.2 million

Pfizer (NYSE: PFE  )

$116.6 million

Simon Property Group (NYSE: SPG  )

$121.6 million

Time Warner Cable (NYSE: TWC  )

$57.3 million

Source: Vanguard. As of June 30.

Now, don't get me wrong: I'm not saying that any of these companies will end up defaulting on their debt. Nor am I saying that the Vanguard fund doesn't follow its investment objective well. But you have to admit that there's a chance, no matter how minuscule, that one or more of these corporate issuers could end up with a credit problem, causing bond values to fall. That's not something that most money-market investors are used to seeing.

Looking elsewhere
The sad thing is that many of these investors could probably do just as well without having to take on this risk. A simple search showed me several FDIC-insured CDs that pay between 2.0% and 2.5% to lock up your money until 2012, the year that corresponds to the Vanguard bond fund's average maturity.

Yet even if this better alternative weren't available, moving your money to a riskier fixed-income investment still wouldn't be the right choice. The whole point of your short-term money is avoiding risk -- otherwise you could earn a much better return than 2.5%.

So, even if low interest rates have you feeling like your short-term savings is a waste of money, don't make an even bigger mistake by chasing yield. The minimal reward isn't worth the extra risk.

The rising stock market has made people wealthy again, but are the good times here to stay? Morgan Housel explains what he thinks about the Big Bounce of 2009.

Fool contributor Dan Caplinger hasn't fallen for the bond-fund trap. He doesn't own shares of the companies mentioned in this article. Pfizer is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy teaches you what you need to know.

Read/Post Comments (1) | Recommend This Article (20)

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  • Report this Comment On September 22, 2009, at 12:12 PM, ikkyu2 wrote:

    I'm surprised we don't hear more about bond funds in this space. My junk bond fund has been by far my best-performing investment over the past three years; the dollar denominated foreign sovereign debt fund has done almost as well. They've outperformed equity-based investments by about 20% per year.

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