Short-term bond
funds carry credit and market risks.
A short-term bond fund may be an attractive investment option for a company that does not engage in stock and financial future transactions. This type of fund also may be used to reduce risks of losses, such as market, credit and interest rate risks, that are implicit in financial market transactions.
Identification
A bond fund is a investment fund that may include corporate bonds, convertible bonds, government bills and notes as well as debt-related derivative products. A short-term bond fund's portfolio manager invests fund assets in various securities and seeks profits within a year or less. This type of investment may be attractive for an individual who does not prefer equity investments. An investor in a bond fund typically receives periodic payments during the bond period and the full amount invested at the contract expiration date.
Market Risk
Market risk is the risk of loss originating from unfavorable security price changes with respect to an investment portfolio. Assume an investor buys 10 shares of stock currently valued at $100 and 20 bonds worth $20,000. After three weeks, market prices for bonds and stocks dropped to $90 and $19,000, respectively. The investor may incur a total market loss of $1,010 if he sells all assets in the portfolio.
Default Risk
Default risk is the risk of loss that may emanate from a bond issuer's inability to reimburse a loan when it becomes due or meet other financial commitments on time. A bond issuer may default on a loan because of bankruptcy or temporary financial problems. In practice, an investor faces default, or credit, risk in short-term bond funds because bond values decrease significantly when borrowers file for bankruptcy or suspend periodic interest payments.
Interest Rate Risk
Interest rate risk is the risk of loss that may arise from adverse fluctuations in interest rates on securities exchanges. Interest rates may vary, depending on economic trends, corporate profitability levels or policies promulgated by central bankers. To illustrate, an investor purchases 1,000 shares of a short-term corporate bond fund valued at $10,000. The median interest rate is currently at 10 percent. If the rate increases to 15 percent after a year, the investor's portfolio may be worth $7,000 and she could incur losses (interest rates move inversely to bond prices).
Risk Hedging
A financial institution or an individual investor engaging in short-term bond fund transactions may hedge (protect against) risk of losses by purchasing investment insurance coverage. If, for instance, the investor buys insurance protection at 90 percent immediately after investing $10,000 in the bond fund, she can reduce losses to $1,000, rather than $3,000, because the insurance company may reimburse up to $90,000.
