Skip to Content
Fund Spy

4 Short-Term Bond Funds That Proved Their Mettle in 2018

Obstacles throughout 2018--particularly rising interest rates and anxious credit markets--provided a challenge to bond investors broadly, but short-term bond funds held their own.

2018 Was a Litmus Test
After a couple of years lagging many other more-aggressive bond categories, short-term bond funds were relatively strong performers in what proved to be a difficult environment for bonds in 2018. The most obvious influence through most of the year was the Federal Reserve’s slow and steady hiking of short-term interest rates. In the second half of the year, pressure on the credit markets increased further, as expectations for U.S. economic growth and inflation were pared back. Even though yields rallied in the last two months of the year, short still trumped intermediate for the full year; the broad short-term bond Morningstar Category delivered 0.92%, while the broad intermediate-term bond Morningstar Category lost 0.50%.

A second and related phenomena was that the yield curve continued to flatten during 2018. As my colleague Miriam Sjoblom pointed out in early 2018, a flattening yield curve narrows the additional yield that an investor is getting paid to take interest-rate risk, so from a fundamental perspective, short funds begin to look more attractive. This happened over the course of the year, as the Federal Reserve tightened monetary policy by raising interest rates four times: in March, June, September, and December. The yield curve flattened considerably, and the spread between the 10-year and 2-year U.S. Treasury tightened, from 54 basis points at the start of the year to 21 basis points at close. Also, by definition, short-term bond funds have less duration, or interest-rate risk, than many longer-maturity-focused options, and this structural characteristic was a significant boon to performance over the course of the year. In short (an intentional pun), investors weren’t giving up that much more yield by not taking additional interest-rate risk.

Short-term bond funds benefited from a muted interest-rate profile, but there were still challenges. Corporate credit is typically a substantial allocation for a short-term bond fund, and this sector ran into difficulties, especially late in 2018. Concerns about the fading impact of fiscal stimulus, the growth in the corporate-bond markets, and the weakening of lending standards all fed volatility across the sector. Shrewd short-term bond funds focused on liquidity, diversification, and thorough risk management, which proved helpful in the last quarter of the year, when lower-quality tiers of credit were under stress.

Short-Term Bond Funds That Excelled
A number of standouts merit particular attention.

Silver-rated  Baird Short-Term Bond (BSBIX) is guided by an experienced team that stays within its guardrails. The fund is run duration-neutral to its Bloomberg Barclays 1-3 Year Index benchmark, but the team has historically added value through thoughtful portfolio construction. Holdings are diversified across numerous names and sectors. In 2018, half of the fund’s portfolio was parked in corporate credit, a fourth in U.S. Treasuries, and the remainder in asset-backed securities, cash, and a sliver in taxable municipals. Around a third of the portfolio was rated BBB, but the team side-stepped difficulties in this sector. The fund delivered 1.5% and landed in the top quartile of its category (distinct peers) for 2018.

Bronze-rated  American Funds Short-Term Bond Fund of America (RMMGX) also benefited from guardrails, but a different type. The fund’s index, the Bloomberg Barclays Government/Credit 1-3 Year ex Baa Index, is similar in maturity to the indexes of other recommendations mentioned here, but the team aims for a higher-quality portfolio with the explicit intention of providing ballast over performance boost during periods of stress. As of December 2018, a typical short-term bond fund held around 68% of its holdings in A or higher rated credits. This fund held nearly 100% in this credit tier, including a 45% slug in U.S. Treasuries. The fund won’t always hold this large a Treasury stake, but it is structured to exhibit defensive characteristics during credit downturns, and in 2018, the 1.4% return of its R6 shares signaled just that. In particular, most of that impressive relative performance was generated as credit sold off aggressively in the last two months of the year, when this fund outstepped 85% of distinct peers.

Bronze-rated  FPA New Income (FPNIX) has a long history of shining when bond yields are on the rise, and 2018 was no exception. In the past, this fund’s broad flexibility landed it in the nontraditional bond Morningstar Category, but given that the managers won’t take duration negative, coupled with a mostly investment-grade focus and persistently low duration, the fund was moved to the short-term bond category in mid-2018. As of December 2018, the fund’s holdings were composed of highly rated securitized fare, including collateralized mortgage obligations (13%), commercial mortgage-backed securities (4%), and agency mortgages (around 18%). Half of portfolio holdings were in various flavors of asset-backed securities (auto loans, credit card debt, collateralized loan obligations, and so forth) that the team extensively stress-tests. In contrast to the two previously mentioned funds, this portfolio held a modest 6% in corporate credit, and this contributed to its attractive relative performance. The fund generated 2.3% for 2018, ahead of 95% of distinct category peers for the period.

Bronze-rated  JPMorgan Limited Duration Bond  (HLGFX) is benchmarked to the Bloomberg Barclays 1-3 Year Index, but unlike this bogy and in the same mold as FPA New Income, this fund explicitly focuses on securitized holdings. Similar to its aforementioned peers, the fund tilts to higher-quality holdings. As of December 2018, the portfolio held 12% in corporate credit, with the remainder of the portfolio parked in collateralized mortgage obligations (39%), asset-backed securities (26%), commercial mortgage-backed securities (7%), agency mortgage-backed securities (4%), and short-term cash equivalents. This portfolio is a relative outlier in the category, given its limited exposure to corporate debt, but the team supporting this fund has exhibited skill in selecting securitized structures in the past, and this year it proved particularly beneficial. These sector holdings, coupled with the fund’s shorter duration, buoyed the its return to 2.0% for the year--better than 95% of distinct category peers.

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