Standout Short-Term Bond Funds in a Low-Yielding World

With interest rates at historic lows, investors who are seeking to pocket higher yields with minimal risk are facing slim pickings. Although there is a growing frustration with the ultralow yields on cash, it's worth noting that there's no true substitute for a money market fund or a certificate of deposit when it comes to a risk-free place to park your cash. And in this article, Christine Benz notes that it pays to be patient with lower yields--especially with the cash in your emergency fund that you cannot afford to lose.

But longer-term investors who have adequate emergency reserves parked in cash might consider stepping out on the risk spectrum by venturing into a high-quality short-term bond fund. Granted, the yields aren't appreciably better right now than what you'd get with a money market fund; Vanguard's Short-Term Bond Index--one of the better offerings in the group--has an SEC yield of just 0.80%. But if bond yields head up in the future, these funds will be able to swap into higher-yielding securities.

With that in mind, we turned to the  Premium Fund Screener to home in on noteworthy taxable and municipal short-term bonds. We immediately streamlined our results by calling up only the distinct portfolios of noninstitutional funds that required an initial investment of no more than $5,000. We then sought no-load offerings with expense ratios lower than their respective category averages.

Short-term bond investors are usually looking to play it safe, so we layered on a screen that kicked out any funds that fell within the low-quality square of the fixed-income style box, allowing us to focus on those offerings with limited credit risk as well as low interest-rate sensitivity. And to seek out offerings that have held up well in down markets, we screened for funds that ranked in the top quartile of their peer group as measured by the bear market percentage rank. Additionally, we required that funds have at least a Morningstar Rating for funds of 3 stars and have managers that have helmed for the fund for at least five years. Premium members can replicate this screen by  clicking here.

Below, we have highlighted three passing funds.

 T. Rowe Price Short-Term Bond (PRWBX)
Veteran manager Ted Wiese typically keeps a sizable share of this Analyst Pick's portfolio in corporate bonds but will also dip into government-, mortgage-, and asset-backed securities and, on occasion, unhedged international bonds. Wiese prioritizes good downside protection rather than taking undue risk to reach for yield. That risk aversion explains the fund's seemingly lackluster relative returns in 2010 and thus far in 2011 (its year-to-date trailing returns lag more than half its peers). Over the long haul, however, Wiese's defensive approach has served investors well. By keeping the portfolio well-diversified and avoiding interest-rate bets, this offering has chalked up strong long-term returns while muting volatility.

 Vanguard Short-Term Bond (VBISX)
Although this longtime Analyst Pick's passive strategy may seem unexciting, its long-term track record is anything but. Morningstar analyst David Falkof points out that from the fund's 1994 inception through early 2011, its rolling three-year returns have topped its category average 96% of the time. (The fund is also topping its average category peer for the year to date.) Although this offering's emphasis on government bonds makes the fund more resilient than its lower-quality peers during flights to quality, investors should note that its sensitivity to interest-rate changes can cause it to lag during periods of rising rates. That said, the fund's low expenses are still likely to provide it with a long-term edge versus its competitors.

 Wells Fargo Advantage Short-Term Muni Bond 
Lead manager Lyle Fitterer is a true bargain hunter who has proved his stripes in navigating difficult markets via timely portfolio adjustments. For example, in mid-2010, he lowered the fund's overall sensitivity to interest rates while ramping up on more liquid investments, helping the fund deliver top-quartile gains for the year. Fitterer's prowess as a bargain hunter was also on display in late 2008 and early 2009, when he seized on the opportunity to pick up bargains in the prepaid gas utilities sector, which helped catapult the fund to a chart-topping 10% gain in 2009. Fitterer's penchant for midquality BBB bonds means that the fund courts risk--particularly during a flight to quality like we saw in 2008--but its competitive yield and value-conscious investment approach give this fund strong appeal for investors who understand its risks.