What does short term funds yield ?

Estimated read time 13 min read

Introduction

Today it is very tricky to navigate the bond world in the investment scenario. Among those poised to provide both stability and income short term bond funds emerge as some of the most attractive options for seekers of such a middle path. They invest in debt with maturities of three years or less  and with much less volatility than stocks. This essay examines a short term bond fund yielding 2.3%. We’ll cover how these funds operate  and parse exactly what’s behind the 2.3% yield and examine the pros and cons of investing in such a fund. Then we will provide you with some meaningful tips on how to choose the appropriate short term bond fund for your needs.

Short Term Bond Funds

In the sea of ever turning investment options  and short term bond funds are viewed as a haven for investors seeking tranquility because they invest in stability and predictable income. These funds take care of capital preservation over high growth opportunities. Unlike their stock market counterparts in funds  and short term bond funds exhibit less volatility  and making them the most appropriate for a conservative investor or one who is approaching retirement and wants to guard his nest egg.

How Do They Work?

These funds pool the money of investors to invest in a diversified portfolio of debt securities that mature within three years or less. These may include

Treasury bills

These are very short term debt instruments of the U.S. government and therefore are considered one of the safest possible investments.

Certificates of Deposit

Essentially a time deposit offered by banks  and where the money is locked away for some stipulated period against an interest rate guaranteed for that period.

Vendors of commercial paper

This entails short term  and unsecured debt that a corporation issues to finance its ongoing operations.

Holding an overall basket of these short term debt instruments the fund aims to provide the investor with a continuous flow of income through regular interest payments and to return the principal amount invested when the underlying bonds mature.

Advantages of Short Term Bond Funds

Here are some of the advantages of investing in short term bond funds in your investment portfolio

Lower Volatility

As compared to equities  and price changes in short term bonds are not as volatile. Hence  and it could be one of the better investments for those investors who cannot stomach fluctuations in the equity market.

Steady Income

Interest on the underlying bonds is usually paid regularly to short term bond funds and hence investors can look forward to a steady stream of income. This will be of much help to retirees or somebody who wants to earn some extra money in addition to the current income being earned.

Liquidity

Since the underlying bonds mature within three years or less  and short term bond funds are pretty liquid.

However  and these benefits do come at certain costs as well

Generally  and short term bond funds offer lesser yield compared to other investments that one can take in such as long term bonds or equities. In other words one exchanges the gain of stability for a potentially lower all around return on investment.

Credit Risk

Though the funds for short term bonds are usually invested in investment grade bonds where the possibilities of default are low  and there is always a chance of default in repaying the debt.

By knowing what is included in these investors can make wiser choices on whether to engage in a short term bond fund based on investment goals and tolerance to risk.

The 2.3% Yield Decoded Under the Hood of Short Term Bond Funds

That 2.3% yield touted for the short term bond fund may be a major statistic but just what it actually means is much more than a percentage. It’s the return  and annualized  and that you can likely get on your money for this particular investment  and expressed as a percentage of the current price of that fund. But don’t consider it an absolute figure and breaking down its components really opens up the inner mechanics of such funds.

Decomposing the Yield

Interest Payments

Income is generated from interest payments that the fund collects from the underlying bonds in the portfolio. All of these bonds carry certain interest rates attached with them  be it T bills  and CDs  and or commercial paper. The fund then passes on a portion of this interest collected to its investors periodically  and usually quarterly or monthly.

Market Fluctuations

The 2.3 percent yield is often a forecast of interest payments in the future and it doesn’t tell you what you get now. The price of the fund itself could fluctuate because of market conditions. For example  and if interest rates rise  and then the prices of existing bonds already within the fund drop. Conversely  and when interest rates fall  and it can cause the value of the fund to rise.

Factors that Affect the Yield

That 2.3% yield you’re seeing is being driven by a lot of things

Underlying Bond Interest Rates

The overall average interest rate of the bonds it holds directly drives the overall yield of the fund. In other words every bond with a higher interest rate contributes to a higher overall yield.

Fund Expenses

These bond funds also come with portfolio management charges  and other operating expenses.  The lower the expense ratio  and the higher the effective yield for you.

Market Volatility

As mentioned above interest rate changes can impact the fund price itself. That is to say if interest rates rise  and the price of the fund will drop even if the underlying bonds continue to make their coupon payments on schedule.

The Bottom Line

Though the 2.3% yield is a good starting point from which to understand the potential return on investment  and remember it’s not a guaranteed figure. You can look deeper  and understand the underlying factors and the potential market movements that help manifest a more realistic return.

Benefits of Short Term Bond Funds

What makes short term bond funds such an attractive set of advantages for investors seeking a haven from the unpredictable storms of the market is the fact that they help people who value capital preservation and predictable income above the high growth prospects that stocks have in their kitty. Let us now consider the benefits which make short term bond funds a great addition to your investment portfolio.

Lower Volatility

One of the significant advantages of short term bond funds is that they behave much less volatile compared to equity funds  and whose prices may swing dramatically. This means your investment will ride smoother  and with less dramatic falls in value. Why? Because the securities themselves are different in nature Short term bonds mature in three years or less and thus move far less with changes in interest rates than do long term bonds. Lower sensitivity also spares investors from extreme price swings  and as is common in the stock market. The sense of stability this provides to the invested capital especially for those closer to retirement or with a lower risk tolerance is something that is very much appreciated.

Stable Income source

It derives from the interest paid on its underlying bonds  and reinvested in ordinary and recurring interest payment streams. These are usually quarterly or monthly  and so they can give an investor a very predictable stream of cash flow. This type of predictable income stream is especially useful for retirees whose income is supplemented by investments or for people who want a continuous cash flow to meet their goals.

High Liquidity

One of the salient features that makes most short term bond funds very attractive is their high liquidity. Due to the short maturities of the underlying bonds of three years or less the fund allows an investor to easily sell their shares and have access to their money in case they need it. Compared with long term investments such as equity or real estate both of which can take time to sell and convert into cash short term bond funds offer more flexibility.

Diversification

Short term bond funds are diversified by their very nature. Normally they comprise a basket of different short term debt instruments. These instruments usually include T bills  and CDs and commercial paper. In turn this diversification aids in spreading the risks across different issuers and classes. In case an issuer defaults on their debt obligations  and the impact on the overall fund will be less as compared to holding a single bond. This aids the risk minimization process and provides more peace of mind for investors.

Relatively Low Minimum Investments

Most short term bond funds have relatively low investment minimums compared to other available investment vehicles. This in itself makes them more accessible to a larger number of investors  and even those who are just entering into the investing fray or have limited capital. These lower minimums thus facilitate starting small and therefore help one to initially begin with a smaller step to slowly build up their investment portfolio over time.

The benefits an investor would gain from a short term bond fund are summarized as stability  and predictable income  and liquidity  and diversification and accessibility. From these advantages you can make out how the funds would serve your investment goals and risk tolerance.

Risks of Short Term Bond Funds

Though short term bond funds offer a bastion of stability and predictable income streams  and this by no means is bereft of its inherent risks.  Investors should acknowledge the potential drawbacks that these funds carry with them before including them in their portfolios.

Lower Potential Returns

As such  and in relation to most other investment opportunities such as equity or long term bonds  and short term bond funds have relatively lower potential returns. You may end up getting a lower return on your investment overall in return for stability and predictability. Short term bond interest rates are usually lower than those available on longer dated bonds or equities. This could mean that your capital growth is ultimately lower.

Interest Rate Risk

Even short term bond funds may not be immune to changes in interest rates a double edged sword. While at first glance the interest rate hike may seem positive  and since new bonds come associated with a higher yield it indeed can be very negative. This is because investors are not so keen on continuing to hold older bonds with lower yields when they can buy newer ones with higher returns. In fact a drop in interest rates works in your favor by raising the price of the fund  and since the value of the existing bonds it holds goes up.

Credit Risk

Although short term bond funds primarily invest in investment grade bonds  and which have a lower default risk it can never be completely ruled out that an issuer may default on their debt obligations. If a bond issuer defaults  and the fund loses the value of that particular bond. This could affect your overall return.  However the risk of default is usually lower for short term bond funds compared to funds holding longer term  and higher risk bonds.

Expense Ratios

As with any other investment vehicle  and short term bond funds involve the incurring of management fees and other operating expenses. These expenses  are collectively called an expense ratio  and are deducted out of the interest collected prior to being distributed to investors. The overall return could be largely eaten into by a higher expense ratio. It is therefore very important to compare the expense ratios of different short term bond funds with each other to make sure that one gets the most from it.

Informed investing will join an understanding of these risks with careful consideration of your investment goals and your risk tolerance to decide whether a short term bond fund is appropriate for your portfolio.

Other Options?

In such an ever expanding universe of investment options  and picking the right one feels a little like finding one’s way out of a maze. Let’s take a look at a comparison of short term bond funds with some popular alternatives

Savings Accounts

Similarities

Both offer a degree of safety and liquidity. Your money is liquid  that is  and there is little or no risk to your principal.

Differences

Generally the yields from the savings account are far lower compared with STBFs. Furthermore the interest rates on your savings account may vary at banks’ discretion  and whereas the income streams from STBF are much more predictable.

Money Market Funds

Similarities

Both provide maximum stability and liquidity. They both deal with highly liquid  and short term debt instruments that enable investors to access their cash easily.

Differences

Short term bond funds can provide slightly higher yields than money market funds. Another difference is that some money market funds may limit the number of times you can withdraw your money in a month. There are no such limitations in the case of short term bond funds.

Certificates of Deposit (CDs)

Similarities

Both provide a fixed interest rate and guarantee a return of your principal if held to maturity. They offer predictable income over some fixed period.

Differences

CDs generally tie up your money for some specified period  and thereby making your cash less accessible. There could be penalties for early withdrawals as well. With short term bond funds  and you have some flexibility to sell the shares on the open market before maturity.

Stocks

Similarities

When you are a stockholder of a company or even have money in a short term bond fund the value of your invested money increases.

Differences

Stocks are normally assumed to be a lot riskier to invest in compared to short term bond funds. The prices of stocks can fall significantly and the potential and possibility of losses are highly likely. Short term bond funds offer an investment with lower volatility and greater emphasis on the preservation of principal.

Remember  and diversification is the key to a balanced portfolio. It cannot be expected for any particular short term bond fund to overshadow its other peers as an investment avenue and pave the way to achieving one’s financial goals.

Conclusion

In short  and short term bond funds give an attractive option to any investor seeking a middle path between stability and the generation of income. They are a haven from market volatility  and with predictable interest payments and cash on tap as required. But an investor has to understand the inherent tradeoffs that come along with these benefits lower potential returns and interest rate risk.Consider the expense ratio  and credit quality  and maturity profile  and tax implications and diversification. Consultation from a financial advisor may also be required to ensure such funds blend cohesively into your overall investment strategy. In the dynamic world of finance  and funds in short term bonds offer an effective instrument for building a stable financial future.

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