Short-term bond funds

By Marvin Appel and Brian Hufford

The average money market fund currently returns about 3/4 percent per year—less than the rate of inflation. That means that if you want your money to be both safe and available, under current conditions you are guaranteed to lose purchasing power over time. In this month's column, we discuss short-term bond funds. With minimal risk, these funds can help you keep up with inflation, or even slightly ahead (if in a tax-deferred account).

What is a short-term bond fund?

Short-term bonds mature in three years or less. Because of their short maturity, bondholders need not wait too long to get their principal returned with interest. This virtually guarantees a positive return for the patient investor. (The only exception would be if a significant number of portfolio holdings default, which has been rare with investment-grade funds.) In fact, the last period when the average short-term corporate bond fund showed losses was a 10 percent decline during 1973-1974. During the last two bond bear markets (1994 and 1999), short-term bond funds on average posted small gains, although they did not quite match money market returns during those years.

The potential drawbacks to short-term corporate bond funds were revealed during a past period of prolonged high inflation (1977-1981), when returns did not keep up with either money market rates or with the cost of living, even though no money was lost during those years.

The Vanguard Short-Term Corporate Bond Fund (VFSTX) yields 3.16 percent and has in most of its 21-year history outperformed the average short-term corporate bond fund.

Adjustable rate funds

There are a small number of adjustable rate funds. These funds invest in mortgage-backed bonds representing payments from adjustable rate mortgages. For the most part, bonds backed by adjustable-rate mortgages are top rated (AAA), and many are issued by the two major government-chartered mortgage companies: Fannie Mae and Freddie Mac.

The potential risks to adjustable rate funds parallel those of these two major issuers, including political risks to the degree of government credit guarantees to these entities, and, of course, broader risks in the mortgage-backed market (such as a potential rise in foreclosures).

Just as the interest rate you pay on an adjustable rate mortgage fluctuates each year in accordance with prevailing interest rates, so, too, does the yield of adjustable rate funds tend to follow moves in interest rates (as do money market funds). Of course, an individual mortgage adjusts its rate only once a year, while the funds hold so many different bonds that the yield ends up being adjusted almost continuously.

Adjustable rate funds kept pace with money market funds from 1985 to 1994. Since 1994, they have beaten money market returns by 1.4 percent per year on average, and the gap during the past three years has been even wider than that.

AMF Adjustable Rate Mortgage Fund (ASARX) has been around for 12 years and is a no-load fund, available only through investment advisors. During that time, losses were recorded in only two months, and losses were well under 1 percent. The current yield of the fund is 2.1 percent.

The Evergreen Adjustable Rate Fund (EKISX) has been more volatile than the AMF fund and sports the same yield of 2.1 percent. The Evergreen family usually charges sales loads, so you should purchase their adjustable rate fund only if your arrangement with a mutual fund supermarket (such as T.D. Waterhouse) allows you to buy the fund without a load and with only minimal transaction cost.