Take A Step Up To Bond Funds

Any mutual-fund investor who uses a money-market mutual fund as a place to accumulate savings may be a candidate for the next step up on the ladder of risk and return - short-term bond funds.

While money funds specialize in interest-bearing securities with just weeks to months to go before maturity, bond funds concentrate on similar securities coming due in one to four years.

Usually, this means short-term bond funds can get a somewhat higher interest yield, at the cost of somewhat greater price volatility and overall investment return.

Paul Merriman, an investment adviser in Seattle, figures that a typical money fund provided a 4.1 percent annual return in the five years through the end of 1996. Over the same span, the Vanguard Fixed-Income Short-Term Bond Portfolio posted an annual total return of 6.3 percent.

“Subtract inflation of 3 percent and you really got 3.3 percent from the bond fund versus only 1.1 percent from money market funds,” Merriman argues. “The trade-off? A little unpredictability.”

In his enthusiasm, Merriman stretches a point or two. He compares a standout example from one category - Vanguard’s short-term bond fund - against the average from the other category. But his ideas have merit.

The most obvious difference between the two types of funds is the behavior of their net asset values per share. Money funds typically maintain a fixed NAV of $1 per share, although they make no legal promise or contractual commitment to do so.

Thus, money fund investors normally do not have to worry about price fluctuations affecting the return they will get or the taxes they will owe.

In a short-term bond fund, by contrast, NAVs do move up and down as interest rates fluctuate, pushing bond prices higher when rates fall and lower when rates rise.

The ups and downs are normally a lot smaller than those in longer-term bond funds. But they make for significant variability from one year to the next in short-term bond funds’ total return.

Is the extra potential in short-term bond funds compared to money funds worth the extra unpredictability? The answer depends greatly on your own circumstances and preferences.

Short-term bond funds may be most attractive to very conservative long-term savers who shy away from riskier propositions, such as stock funds, but who don’t expect to need money from their accounts any time soon.