Best Short-Term Bond Funds for the Long Term

These funds can provide income-hungry investors with a higher yield than money market funds.

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U.S. News is releasing a series of stories highlighting top-rated mutual funds according to various categories. These funds have performed well over the long term, are rated highly among the industry's analysts, and have low minimum investments, making them accessible to all investors—big or small. This is the second piece in a series of stories highlighting 10 categories that make up U.S. News's 100 Best Mutual Funds for the Long Term.

For investors looking for a bit more yield than what they're getting on savings and money market accounts these days, short-term bond funds may be worth considering. Since the Federal Reserve set interest rates to near-zero levels, yields on savings and money market accounts have been nearly nonexistent (the average money market account recently yielded 0.68 percent, while the average one-year CD yielded 1.07 percent, according to Bankrate.com). Short-term bond funds are offering more generous payouts, with yields that are generally 2 percent or higher.

After money market accounts, short-term bond funds are the next step out on the risk spectrum. Morningstar defines short-term bond funds as those that invest in bonds with durations (a measure of interest-rate sensitivity) of one to 3.5 years. Investors should know that the higher yield offered by short-term bond funds comes with more risks. These funds can be a long-term holding for investors who want to allocate a part of their portfolio to bonds with decent yields and low interest-rate risk relative to longer-term offerings.

[See top-rated funds by category ranked by U.S. News Score.]

"It's been such a long time since investors have had to worry about losses in their short-term bond funds because rates have been steadily heading downward," says Miriam Sjoblom, associate director of fund analysis at Morningstar. Some investors have a misconception that they can't lose money in short-term bonds funds, when in reality it's possible if the Fed begins to hike interest rates or in the case of other distress in the economy. The most recent example was Schwab YieldPlus (symbol SWYSX), which many investors considered a low-risk holding. The fund lost more than 35 percent in 2008 because it was heavily invested in some mortgage-related bonds in the fund that plummeted in value. Investors later sued Schwab and won.

[See The Decade's 10 Worst Fund Disasters.]

Managers of short-term bond funds invest in a wide range of fixed-income assets, including treasuries, mortgage-backed bonds, corporate bonds, some foreign holdings, and at times, high-yield bonds, Sjoblom says. "For investors looking to move into a bond fund to get a bit more yield, they need to realize they need to have a longer time horizon than they would in a money market fund," she says. With that in mind, here are U.S. News's best short-term bond funds for the long term:

Lord Abbett Short-Duration Income (LALDX). Currently, this fund is light on U.S. government holdings and heavy on corporate bonds and mortgage-backed securities. Last year was a banner year for the fund, as it finished near the top of its category with a return of 17 percent. The fund, which currently yields 4 percent, has gained an annualized 5 percent over the past decade. Its annual fees are 0.68 percent.

Thompson Plumb Bond (THOPX). You won't find any exposure to U.S. government securities in this fund. Instead, management had loaded up on corporate bonds, which now make up more than 80 percent of the fund's total assets. The portfolio also has a rather large allocation to cash (30 percent). For a bond fund, Thompson Plumb offers a relatively wild ride: Over the past decade, it has finished four years in the bottom quartile and four years in the top decile of its category, according to Morningstar. The fund, which yields 3 percent, has returned an annualized 7 percent over the last 10 years. Its annual fees are 0.75 percent.

Weitz Short-Intermediate Income (WEFIX). This all-weather fund landed in the top of its category in both the 2008 downturn and the subsequent rally in 2009. The fund is fairly concentrated in corporate and mortgage-backed holdings. Another 20 percent of the fund's assets are in cash. Management has the option to invest 15 percent of the fund's asset in a mix of convertibles, high-yield bonds, or stocks. The fund, which yields 2.5 percent, has returned an annualized 5 percent over the past 10 years. Its annual fees are 0.62 percent.