Short-term bond funds vs. CDs

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Savers just cannot catch a break in today’s interest rate environment. According to Bankrate’s archives, the average one-year CD has yielded under 1 percent since September 2009 — and under 0.5 percent since December 2010.

After the erosion of purchasing power through inflation, savers are kind of paying banks to keep their money. But rather than seeking higher yields in longer CD maturities, savers do have more liquid options as I blogged about last week.

But there are even more. I recently spoke with Chris Ravsten, founder of Foxstone Financial in Denver, Colo., who suggested short-term bond funds as an antidote to low CD rates.

With interest rates set to rise at some point in the future, bond fund investors have received plenty of warnings about what will happen to long-term interest rates. When rates increase, the value of existing bonds will fall and that can lead to losses for bond fund investors.

But there are some types of bonds that do well in a rising rate environment, according to Ravsten.

“We use no-load bond funds,” Ravsten says.

Bond funds “are very liquid and clients are able to get their money out of them in about three days — which is in most cases plenty of time in the event of an emergency,” he says.

A no-load fund will have no sales commission upon buying the fund or on selling. But that doesn’t mean all no-load funds are fee-free. There may be a redemption fee imposed upon selling or some funds may specify a length of time that the fund must be held in order to avoid a fee.

Any fees investors pay will ultimately reduce the return on investment, which can make the entire exercise of finding higher yielding investments moot. Before investing in anything, be sure to understand the fees.

Certain types of bonds perform better than others in a rising rate environment, including “floating rate bonds that tie into bank loans, TIPS and high-yield junk bonds do well,” says Ravsten.

To avoid falling bond prices when rates increase, he recommends sticking to the short- to mid-term.

While some bonds will do better than others in a rising rate environment, others fare much worse.

According to a story from April, “Bond funds to avoid as rates rise,” by Jonenelle Marte, investors may want to beware of “bonds with longer maturity, zero-coupon bonds, and issues with little credit risk.”

From the story:

Long-term Treasurys, for example, are especially sensitive to interest rate risk because few factors other than rate movements affect their yields. Indeed, the long-term government bond fund category at Morningstar carries the most interest rate risk of any funds, with an average duration of 14.16 years. And these funds have already seen losses: The average fund lost 1.53 percent in the first quarter after falling 8.63 percent in the fourth quarter of 2010, according to the fund tracker.

The story identifies municipal bond funds, zero-coupon bond funds and Ginnie Mae funds as possible money-losers when rates go up.

What other options are there?

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