You're supposed to earn higher returns when you take on more risk. But with one type of bond fund, you actually get paid less.

Short-term bond funds have been billed as an attractive substitute for money-market mutual funds. With advertised yields that are higher than money funds and billed as having minimal risk, these funds seem like a winner for those looking to earn the most income they can while staying safe.

But as some investors are discovering, short-term bond funds aren't risk-free. In addition to having yields that fluctuate over time, you also risk losing some of your principal.

No $1 peg
Unlike money-market funds, which strive to maintain a share price of $1, the share price of short-term bond funds fluctuates. Although the short-maturity bonds these funds own minimizes the ups and downs you'll experience, it can still make a big difference. According to a recent Marketwatch article, these funds have lost an average of 0.3% in the past month alone -- a far cry from the 0.4% gains that many money-market funds have earned.

Now, granted, 0.3% is nothing to lose sleep over. But do you really want to be taking any risk at all with this money? Remember, we're talking about the cash portion of your portfolio -- the part that you count on to be secure no matter what happens with your other investments.

Credit and interest rate risk
The plight of short-term bond funds offers a good chance for a reminder on the types of risks that bond investors take on. When you own bonds or a bond fund, you're assuming the risk that a given bond's issuer won't be able to repay you. As we're discovering, investors think the U.S. Treasury is a good credit risk -- rates on short-term Treasury bills fell precipitously yesterday. But what about other issuers? There's not as much confidence there -- especially when you start looking at financial companies like Countrywide (NYSE:CFC) and the problems they've had with their commercial paper.

A close look at the holdings of these funds sheds some light on the risks they carry. For instance, the Fidelity Ultra Short Bond Fund (FUSFX) owned some derivative securities as of the end of June. One derivative involves a promise to pay Morgan Stanley (NYSE:MS) if Ameriquest Mortgage Securities defaults on its bonds, while another requires a payment to Citigroup (NYSE:C) if there's a default by an entity called the Carrington Mortgage Loan Trust. You'll also find various securities from entities related to NovaStar (NYSE:NFI), Fremont General (NYSE:FMT), and the now-bankrupt New Century.

The other risk that short-term bond funds entail is that interest rates may rise. If rates rise, then the value of your shares will fall -- not as much as longer-term bond funds, but enough to make a difference in your total return. Often, that will offset any higher interest payments you receive. For example, the Fidelity fund has a current yield of 5.54%, well above most money markets -- but the fund has lost over 1% so far this year.

Lower payouts?
However, it's not a sure thing that you'll even enjoy higher yields. A quick look at the Vanguard Short-Term Treasury Fund (VFISX) shows a current yield of 4.53%. That's lower than the Vanguard Treasury Money Market (VMPXX), with a current yield of 4.70%.

When looking at your portfolio, it's tempting to focus on stocks and ignore the lower-risk, lower-return assets. Yet while you know that stocks are risky, it's the risk in those supposedly stable investments that will throw you for a loop if something goes wrong. By understanding and managing those risks now, you can take steps to prevent such problems from affecting you.

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Fool contributor Dan Caplinger has most of his short-term cash in Treasuries. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy is as safe as can be.