Short-duration bond investments have been popular with investors who are searching for more yield than may be found in savings accounts or money market funds, or who are wary of rising interest rates.
"Short duration strategies may be appealing in this interest rate environment, but even among short-duration funds and exchange-traded funds (ETFs), there are a lot of differences, so you need to choose carefully," says Rob Galusza, manager of Fidelity® Conservative Income Bond Fund (FCONX).
Deciding whether a short-duration strategy makes sense for you, as well as choosing the right short-duration strategy, requires you to understand your own personal investing goals, risk tolerance, and financial needs. It's also important to understand how duration and credit quality might play out in different market conditions. Duration is a measure of interest rate risk.1 (Read: Duration: Understanding the relationship between bond prices and interest rates.)
The short-duration universe
When compared with long-duration bond funds of a similar credit quality, short-duration choices generally come with less sensitivity to rising rates and, all else being equal, lower yields. These differences in rate sensitivity and yield can also occur within the range of short-duration funds and ETFs on the market. For example, the Morningstar ultrashort bond fund category has an average duration of 1 year or less. On the other end of the spectrum are short-term bond funds offering durations of up to 3.5 years.
If interest rates rise within a short period of time, shorter-duration bonds may experience lower price volatility relative to longer-duration bonds. When it comes to credit quality, improving credit conditions may favor higher-yielding, lower-quality bonds; likewise, in worsening credit conditions, high-yield debt might underperform higher-quality issuers.
Factors to consider
If you have decided that a short-duration strategy makes sense for you, the factors involved in choosing an appropriate option are pretty much the same ones you would consider for any investment: your personal situation, your overall asset allocation, and your market view.
Weigh your goals. How soon will you need the money, and how much volatility or risk of loss can you tolerate? The less willing you are to risk losses or the sooner you may need the money, the more you may want to think about conservative, short-duration, high-credit-quality options.
Consider your market outlook. If you expect long-term rates to stay low for a long time, you may want to consider longer-duration options. If you think long-term rates may rise, you might want to look at the shorter-duration end of the spectrum.
Assess your outlook for credit risk. In recent years, defaults have been low and corporate debt has performed well. If you think these trends will continue, that might argue for a high-yield short-duration bond strategy. But if you think conditions might turn, you might want to stick with higher-credit-quality bond funds.
Think about inflation. Inflation has accelerated modestly in recent years, so it does pose a risk, particularly to the most conservative short-duration strategies. Inflation can eat into the value of bond returns, and that risk could affect the lowest-yielding options the most. So, if you think inflation will continue to rise, you may want to consider more aggressive, higher-yielding options within the short-duration category or shorter-maturity TIPS (Treasury Inflation-Protected Securities).
Different situations, different strategies
Let's look at 3 hypothetical investors who are considering short-duration funds for different reasons. These simplified examples look at credit quality, yield, and duration. You will also want to consider cost, performance, transaction costs, and other criteria when making a decision. In addition, you might want to consider owning individual bonds, a bond or CD ladder, or other options along with bond funds. (To learn more about the role of individual securities, read Bonds vs. bond funds)
1. Sonia wants to boost her retirement income
Sonia is a retiree who holds enough cash to cover about 18 months of expenses in a bank savings account averaging 0.10% net interest.3 She has been frustrated by low yields over recent years. While she is risk averse and knows she will need that money in the short to intermediate term, she is willing to explore other options to increase income, as long as she remains comfortable with the amount of risk it adds.
She decides to keep a third of her expense money in a government money market fund averaging nearly 2% net yield, to cover any expenses over the next 6 months.3 She puts the rest of her cash in a very conservative, investment-grade short-duration bond fund with an index duration of just 0.36 years. While the index yield is only 2.45%, it's a meaningful increase from the yield on her cash. And with high credit quality and low duration, it’s an amount of risk she thinks she can live with.
2. Hank wants to shift his asset mix
Hank is 50 years old and is saving for a retirement that will begin in 10 years. He has an investment mix designed for growth, which includes 25% that is invested in long-duration bonds and 5% that is invested in cash.
Hank has a strong point of view that the economy will accelerate and that interest rates will rise in the coming years. He is worried that the rising rates he expects will hurt the performance of the fixed income portion of his portfolio, and he wants to explore ways to limit the impact while maintaining an allocation to fixed income within his overall investment mix.
Hank decides to move part of his fixed income holdings to short-duration funds. Because of his outlook for the economy and rates, he decides to invest in a mix of investment-grade bond funds with index yields of 2.3% to 2.5%, and high-yield corporate short-duration bond funds with an index yield of nearly 5%.
By moving a portion of his investments to short duration, Hank has decreased the overall interest rate risk of his portfolio, while increasing the diversification of his bond holdings by adding a greater variety of maturities and issuers to his investment mix. At the same time, by choosing high-yield and investment-grade corporates, he has tried to earn more yield than other short-term options and accepted the increase in risk.
3. Jacob is saving for a vacation home
Jacob has been saving in a broadly diversified bond fund to buy a second home to enjoy on vacations and in retirement. He expects to have saved enough in about 3 years. While he has enjoyed strong performance and income from his fund in the past, he is concerned about the risk of losses in the future, and he wants to explore short-duration options that would help insulate his nonretirement portfolio from the risk of rising rates—as well as the impact of taxes. Read more about tax implications of bonds and bond funds.
Jacob knows his time frame is about 3 years, and he's looking to match it to the duration of a bond fund. So he chooses a defined maturity fund whose price sensitivity to interest rate changes declines gradually over time. The high credit quality of the fund he chose and a duration that matches his timeline makes him feel confident that he can live with the risk involved as his investment timeline comes to an end.
Another option would be a limited-term municipal bond fund with an index duration of 2.73 years and an index yield of 2.04%. Jacob assumes his federal tax rate is 32%, so he estimates that on a tax-equivalent basis, the index yield of this investment might be estimated at about 3% (that is, the equivalent pre-tax yield, were the income from the investment subject to federal tax). But as Jacob's investment horizon shortens, he may consider continued shifting into shorter-duration choices in order to minimize his risk of principal loss before the purchase of his second home.
Next steps to consider
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