How to Choose a Short-Term Bond Fund

Emory Zink: Investors in short-term bond funds are typically seeking safety and have a low tolerance for losses. Shrewd offerings deliver on this goal by focusing on liquidity, diversification, and thorough risk management. Interest-rate calls are difficult to get right, so you want to invest with a manager that has a disciplined approach to limiting the fund's interest-rate sensitivity. Managers that are taking more liquidity or credit risk could expose investors to volatility, which may lead to outflows that exacerbate liquidity troubles, as we saw during the financial crisis.

A few of our recommendations in the short-term bond Morningstar Category, which take these concerns into consideration, include Baird Short-Term Bond, which earns a Gold rating on its cheapest share classes. This strategy 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 2019, half of the fund's portfolio was parked in corporate credit, a third in U.S. Treasuries, and the remainder in asset-backed securities, mortgage-backed securities, and cash. The team doesn't shy away from BBB rated fare, either, but has exhibited good judgment with those selections historically.

Another option is Fidelity Limited Term Bond, which earns a Silver rating on its cheapest share classes. The strategy is benchmarked to the Bloomberg Barclays Government/Credit 1-5 Year index. The team manages duration closely to this benchmark, and subsequently, this offering tends to court modestly more interest-rate risk than its typical peer. The portfolio invests across a bevy of government, corporate, and securitized bonds, and it will hold up to 5% in below-investment-grade fare, but the research and risk management applied to these selections is both thorough and thoughtful.

And for an investor wanting something without the heavy corporate-credit bias, there is JPMorgan Limited Duration Bond, which earns a Silver rating on its cheapest share class. This strategy is benchmarked to the Bloomberg Barclays 1-3 Year Index, but unlike this bogy, it explicitly focuses on securitized holdings, such as agency mortgage-backed securities, collateralized mortgage obligations, and asset-backed securities. 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 gives it an advantage during periods of credit stress relative to peers holding larger allocations to corporate credit.