Understanding Short-Term Bond Funds

Short-term bonds are a critical part of a well-diversified portfolio. They can provide much needed stability during times of stock or bond market volatility.

Investing in a short-term bond mutual fund as opposed to buying individual bonds offers additional advantages, including professional money managers for bond selection, greater diversification of holdings, and lower minimum investments.

But before you invest in a short-term bond fund, it's important to understand how they work so that you can make an informed decision. This article should give you all the tools you need from a recap of bond basics to how short-term bonds fit into the broader scheme of a diversified portfolio.

What is a bond?

A bond is a loan from an investor to a corporation or government entity, who are commonly referred to as issuers. The issuer promises to make regular interest payments to the investor, and to pay the loan in full when the bond matures.

What kinds of bonds are out there?

Bonds are classified according to the category of the issuer, the issuer's credit worthiness, time to maturity and duration.

Issuer Category. Bonds can be categorized as U.S. Treasury securities, U.S. government agency bonds, municipal bonds, corporate bonds, or global bonds.
Credit Worthiness. Credit ratings are a measure of an issuer's ability to honor their debt. Their quality can be rated as high, medium or low (high and medium quality are considered investment grade, and low quality is a 'junk bond').
Time to Maturity. Short-term bonds generally mature in three years or less from the date of issue, intermediate-term bonds mature in 3-10 years, and long-term bonds mature in more than 10 years.
Duration. Duration measures a bond's sensitivity to interest rate changes. It takes into account the bond's maturity and the amount of interest it pays. The greater the duration, the more a bond's price will fluctuate with interest rate changes.

How are short-term bonds different?

Short-term bonds are generally less volatile than bonds with longer maturities. Here's why:

Lower volatility. Bond prices rise and fall based on interest rates. When interest rates change, the value of bonds with longer maturities will vary more dramatically. Therefore, short-term bonds are generally much less volatile than longer-term bonds, especially in an unstable interest rate environment. However, during periods of declining interest rates, the payment stream from long-term bonds will not be affected as severely as it would be from short-term bonds.
Fewer inflation worries. Bonds with longer maturities are more susceptible to the risk that their fixed income will fail to keep pace with inflation. Also, because interest rates tend to rise in an inflationary environment, long-term bond prices may fall faster as the purchasing power of their income decreases.
Less time for uncertainty. When bonds take longer to mature, there's more time for a variety of factors to have a negative impact on an issuer's ability to pay bond holders. The risk of an issuer going bankrupt, a bond being called back, or even an extended market crisis is much higher over a 30-year period than a two-year period.

Because long-term bonds are more volatile, they pay higher interest rates than short-term bonds. This means an investor can potentially earn greater returns on longer-term bonds in exchange for the additional risks mentioned above.

How should short-term bonds be used in my portfolio?

Core holding. Short-term bonds are a critical portion of the "core" stock and bond holdings in a broadly diversified portfolio. A typical portfolio could have 5 - 25% of assets allocated to short-term bonds based on risk tolerance and time horizon.
Stabilizer. Because of their relatively stable prices, due to low interest rate exposure, short-term bonds will work to dampen the overall volatility of your portfolio.
Income. Short-term bonds can give a portfolio an additional source of regular income.

Why choose a bond fund?

Investing in bond mutual funds instead of individual bonds offers many advantages:

Professional management. Professional money managers will research, select and continuously evaluate investments.
Greater diversification. Bond funds allow you to own shares of a diversified portfolio containing numerous different bonds instead of dedicating your investment to a smaller amount of individual bonds.
Lower minimum investments. An individual bond generally costs around $1,000. If a bond fund contains 100 bonds, you would need $100,000 to achieve similar diversity through individual bonds. Bond funds, on the other hand, often have a minimum investment of $1,000.
Flexibility. Bond fund units can easily be bought or sold at any time with very little hassle. Selling individual bonds requires finding an interested buyer on the open market.

What are the risks?

There are many types of short-term bond funds available that are subject to varying degrees of risk. As with any mutual fund, the principal value and investment returns will fluctuate over time, so that when an investor's shares are redeemed, shares may be worth more or less than original cost.

Short-term bond funds are exposed to many of the same risks that longer-term bond funds are subject to:

Credit risk. The issuer of the bonds within the fund may not meet their payments.
Inflation risk. Inflation could out pace the bond fund's income.
Interest rate risk. Fluctuations in interest rates will affect the price of a fund's bonds.
Mortgage-backed securities risk. These securities are subject to prepayment risk and may be sensitive to changes in prevailing interest rates. When interest rates rise, the value of fixed income securities generally declines.
Foreign securities risk. Foreign securities may entail greater volatility due to foreign economic and political developments and currency fluctuations.

How can I add a short-term bond fund to my portfolio?

Transamerica Funds offers Transamerica Short-Term Bond, a new fund that's designed to add stability and support to your portfolio's core holdings.

If you're interested in adding the Fund to your portfolio, talk with your financial professional.

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