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4 Short-Term Bond Funds to Calm Rising-Rate Jitters

Forget about calling the bond market bottom. These funds will let you rest easy.

Could 2018 mark the beginning of the long-anticipated bond market sell-off? By mid-January, the yield on the 10-Year U.S. Treasury note rose above 2.6% (its highest level since mid-2014), and the prognostications calling for higher yields in 2018 started rolling in.

The case for higher yields sounds reasonable enough. Developed-markets central banks, led by the Fed, have been taking steps to normalize monetary policy. The Fed has gradually hiked its target rate since December 2015 and signaled more hikes to come in 2018; it also began trimming the size of its bond portfolio starting in October 2017.

The European Central Bank and Bank of Japan haven’t advanced as far down this path but have been moving in the same direction since they’ve begun slowing their bond purchases. Meanwhile, a sizable planned increase in Treasury issuance in 2018, plus expectations for more robust growth and higher inflation, could all nudge Treasury yields higher.

We’ve seen this movie before, though. Many bond investors have positioned for higher yields at various times over the past several years, only to miss out when yields failed to rise or dropped further. As recently as early 2017, similar forecasts called for higher Treasury yields, which instead marched lower, boosting the Bloomberg Barclays U.S. Aggregate Bond Index to a healthy enough 3.5% return for the year, outgaining its 2.6% yield at the start of 2017.

There are compelling and nuanced reasons to suggest that this time could be different, just as there are persuasive arguments supporting the view that today’s fears about rising rates could be overblown. U.S. Treasury yields are currently among the highest developed sovereign yields available, for instance, increasing their attractiveness globally, while the deflationary impact of technological innovation could keep a lid on inflation.

Because bond yield forecasts have been so difficult to get right in recent years (a Wall Street Journal headline from November 2017 declared last year’s predictions “pathetically wrong”), we’ve often advised against shifting around portfolios to protect against the possibility of short-term pain in the bond market. As my colleague Sarah Bush recently wrote, no matter where yields go from here, intermediate-term bond funds still offer diversification benefits in an equity-heavy portfolio and make sense as a core part of a long-term asset-allocation plan. 

Still, it is worth noting that, as the Fed’s target-rate hikes have driven short-term bond yields higher and the yield curve has flattened, the value proposition for owning a short-term bond fund has improved. For example,  Vanguard Short-Term Bond Index’s (VBISX) SEC yield reached 2.2% on Jan. 24, 2018, an increase of 1.7 percentage points from its early 2013 low of 0.5%. Over that same period,  Vanguard Total Bond Market Index’s (VBMFX) SEC yield rose by just 1.1 percentage points to 2.7%. So, while Vanguard Total Bond Market Index began the period with a yield advantage of more than a percentage point over its short-term sibling, that advantage has narrowed to less than half a percent today, which means investors don’t have to give up as much yield in exchange for taking less interest-rate risk.

Another way of looking at it is that the short-term fund currently offers investors more yield per unit of duration (2.2% divided by 2.7 years, or 0.8%) than its intermediate-term counterpart (2.7% divided by 6.1 years, or 0.4%), which wasn’t the case five years ago, tilting this reward/risk ratio in short-term bond funds’ favor.

For investors who don’t want to take much interest-rate risk in their bond portfolios, here’s a list to consider. The temptation to reach for yield by taking more credit and liquidity risk has run high in the postcrisis years, so our favorites include funds that take a measured approach toward credit risk and haven’t strayed from that discipline. Relatively low fees also mean these don’t have to take excessive risks in order to clear a high expense hurdle.

 Baird Short-Term Bond  (BSBIX) doesn’t get overly fancy. Mary Ellen Stanek and her long-tenured team of portfolio managers keep the fund’s duration--1.9 years as of Dec. 31, 2017--close to that of its Bloomberg Barclays U.S. Government/Credit 1-3 Year Index, avoid junk bonds, and tread lightly in mortgages and other securitized fare with a high degree of cash flow uncertainty or liquidity concerns. The team specializes in short-dated investment-grade corporates, especially midgrade A and BBB rated fare, and has done a good job selecting bonds and balancing that exposure with high-quality U.S. government debt. The 0.30% price tag charged by its institutional share class ranks among the lowest charged by an actively managed bond fund but requires a $25,000 minimum. That fee advantage goes away for the fund’s no-load investors, who pay 0.55%.

 Fidelity Short-Term Bond (FSHBX) has maintained an appealingly cautious profile since its subprime-related troubles during the financial crisis prompted a management change and reformation in 2007. After cleaning house, lead manager Rob Galusza has stuck to a similar style as the Baird team’s here, tying the fund’s duration to the same benchmark, eschewing below-investment-grade issues, and keeping exposure to securitized fare modest. Investors in the fund’s no-load share class get a slightly better deal here from its 0.45% expense ratio. 

For those comfortable with a more eclectic approach,  PIMCO Low Duration (PTLDX) is worth considering. Since taking over from Bill Gross in 2014, managers Scott Mather and Jerome Schneider have continued to make full use of the firm’s expansive tool kit. They focus on U.S. investment-grade bonds but adjust the fund’s interest-rate sensitivity (its duration was roughly one year as of Dec. 31, 2017) and express views on rate and currency markets outside the United States. In keeping with PIMCO’s view that corporate debt markets are already pricing in a rosy economic scenario, the fund hasn’t taken much corporate credit risk of late. Its institutional share class charges a reasonable 0.45%, but investors may want to think twice before investing in some of the fund’s other share classes. Its D no-load shares charge a steep 0.75%, for instance. But for investors who want even less interest-rate risk and fewer strategy embellishments,  PIMCO Enhanced Short Maturity Active ETF (MINT) is a fine accessible option with an appealing 0.35% expense ratio.

 Vanguard Short-Term Bond Index  (VBISX) is as simple as they come. The fund tracks the Bloomberg Barclays U.S. 1-5 Year Government/Credit Float Adjusted Index, so its duration tends to run a bit longer than the category norm. With more than 60% of the portfolio in U.S. Treasury and agency debt, its credit quality is also on the high end relative to category peers. That may put the fund at a disadvantage relative to yield-seeking peers during favorable environments for credit risk, but in exchange, investors get peace of mind during market tumult and the ongoing advantage of bargain-basement fees: 0.15% on its Investor shares and 0.07% on the Admiral shares ($10,000 minimum) and exchange-traded fund version.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.