Short-term corporate bond fundsHow they're valued: Short-term corporate bond funds invest in bonds that corporations issue. Short-term bonds have an average maturity of one to five years.
Risks: As is the case with other bond funds, short-term corporate bond funds are not FDIC-insured. Investment-grade short-term bond funds can reward investors with higher returns than munis or Treasuries. But along with the greater reward comes greater risk. There is always the chance that companies will have their credit rating downgraded or run into financial trouble and default on the bonds.
Liquidity: You can buy or sell your fund shares every day. In addition, you usually can reinvest income dividends and make additional investments at any time. However, it's possible to suffer capital losses. See caveats, below.
Pros and cons: Corporate bond funds generally pay higher interest rates than government bonds, but government bond funds usually carry tax advantages and are lower risk. You may be better off buying corporate bond funds in your tax-advantaged retirement plan. When short-term bond fund interest rates get too low, you may be better off avoiding them because the lower yields may not be worth the risk of default.
Where to find them: You can purchase short-term bond funds at brokerage and mutual fund investment firms.
Caveats: Although many of the riskier short-term corporate bonds may have closed or succumbed to market pressures, investors still need to be vigilant when considering funds advertising yields too good to be true. Understanding how the fund achieves those yields and whether it's taking on unnecessary risk will help investors steer clear of potential losers. Oftentimes bond funds with higher expense ratios take on higher risk to stay competitive with peers. These vehicles are not as sensitive to interest rate changes as other types of bonds. Nevertheless, in the 12 months through May 31, short-term corporate bond funds fell 0.37 percent on average, according to Morningstar. Year-to-date they're up 3.57 percent.
Words of caution: "Some of the people with short-term bond funds in the fall of 2008 got burned because apparently many of them had some of the subprime mortgage securities in their portfolios. They may have taken on more credit risk in order to maximize yields. With short-term corporate bonds, or any kind of bonds for that matter, composition and ratings are going to be key."-- Barbara O'Neill, Ph.D., CFP, and financial management specialist at Rutgers University in New Brunswick, N.J.