Don't Fall for Short-Term Bond Funds

With interest rates falling, savers are scurrying to avoid suffering a big drop in income. One commonly proposed solution, however, could leave you with a much bigger loss.

Short-term bond funds are often touted as a substitute for money market funds. Often, short-term bond funds pay slightly higher interest rates. In addition, when rates are falling, you can often earn extra return from the higher bond prices than lower yields bring.

But once interest rates are already low, short-term bond funds are a bad bet. Historically, you're better off putting up with minuscule returns from money markets than accepting the potential for capital losses in a short-term bond fund.

When times are good
Unfortunately, many fund investors chase performance, and recent events have boosted short-term bond funds greatly. Over the past year, funds like Vanguard Short-Term Treasury (VFISX) are up nearly 10%, as Treasury yields made fixed income -- and Treasury securities in particular -- a surprise winner in 2007. With continuing trouble in the credit markets, the trend has continued so far in 2008, as the fund has picked up another 2.5% year to date.

That's great for investors who decided to buy short-term bond funds a year or two ago -- when money-market funds were still yielding more than 5%. If you're looking at buying into one of these funds now, however, you need to know what you're getting into.

What goes up ...
The other side of the coin with short-term bond funds is that when rates hit bottom, there's nowhere for bond prices to go but down. Consider, for instance, the last interest rate cycle. On June 30, 2004, the Fed made the first rate hike since 2000, going from 1% to 1.25%. Two years later, rates reached 5.25%.

During those eight quarters, the Vanguard short-term bond fund returned only 3.84%. Meanwhile, a comparable money-market fund, the Vanguard Treasury Money Market, had a total return of more than 5%.

Taking on risk
In addition, not all short-term bond funds own Treasuries. To get even more yield, short-term corporate funds own bonds issued by private companies. For instance, Vanguard's Short-Term Investment-Grade Fund (VFSTX) has a wide range of bonds, with issuers ranging from Oracle (Nasdaq: ORCL) to Nordstrom (NYSE: JWN). That pushes the fund's current yield to 4.44%, compared to just 2.09% for its Treasury fund.

But some short-term corporate funds have gotten trapped with toxic holdings. The Metropolitan Strategic Income Fund (MWSIX), for example, holds a host of collateralized debt obligations from issuers including Bear Stearns (NYSE: BSC), Morgan Stanley (NYSE: MS), and Citigroup (NYSE: C). Thanks in large part to CDOs getting hammered, the fund is down 6% in the past year.

There's no disputing that short-term bond funds have enjoyed high returns lately. But now isn't the right time to buy them. For savers looking to keep earning decent interest on their savings, the risk of losing principal -- either because of interest rate hikes or continuing credit problems -- doesn't justify the limited upside.

To learn more about getting the most from your savings, read about:

• Where you can find the best rates;
• How savers are bailing out ailing banks; and
• How to survive when interest rates fall.