Understanding Short-Term Government Bond Funds
In times of low interest rates on savings and investments, investors will be looking for places that pay a higher rate of interest yet remain safe options for their money. Short-term government bond funds may be an attractive alternative to earn higher interest with relative safety. Investors should understand how to analyze bond funds to make the best choice for a short-term government bond fund.
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Identification
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Bond funds hold debt securities and government bond funds own debt securities issued by the U.S. government or agencies of the government. A short-term government bond fund will hold bonds with maturities of less than five years. The majority of short-term U.S. government funds are offered by fund families that sell load funds. For the no-load investor, both Fidelity Investments and The Vanguard Group have short-term government bond funds for purchase.
Function
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A short-term government bond fund will own U.S. Treasury or agency securities with maturities of five years or less. Investors own shares in the fund. The interest earned on the government bond portfolio will be paid to the investors as monthly dividends. Bond fund investors have the choice of receiving dividends in cash or reinvesting them into more shares of the fund. Mutual fund shares are purchased from and redeemed directly with the mutual fund company.
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Effects
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The yield of short term government bond funds will reflect the rates of the bond yields. For example, in June 2010, the Thornburg Limited Term U.S. Government Fund had a distribution yield of 2.75 percent and the Vanguard Short Term Federal Fund was yielding 1.75 percent. The difference is based on the types and maturities of the bonds in the portfolio. Bond prices and bond mutual fund prices decline when interest rates increase and increase when interest rates fall.
Potential
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Government bond funds can be compared and evaluated using several portfolio characteristics that will be available on the fund's web page. The expense ratio is the amount of the portfolio's income the mutual fund company charges to manage the fund. A lower ratio is better when comparing funds. A bond fund's portfolio average maturity and average duration will tell you how much the share price will be affected by changes in interest rates. A fund with a shorter average maturity and duration will have a more stable share price. The duration is an approximate indicator of the percentage the share price will change with a one percent change in market interest rates. For our two example funds, the Vanguard fund has a duration of 2.1 years and the Thornburg fund has a 2.7 year duration. If interest rates increase one percent, the share price of these funds would fall about 2.1 and 2.7 percent, respectively.
Considerations
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Investors who buy short-term government bond funds are looking for safety and stability of principal. They are expecting interest rates to increase. A shorter average duration should be given a high priority when evaluating one of these funds. Many of the funds in this category have sales charges. For example, the Thornburg bond fund has a maximum upfront sales charge of 1.50 percent. Investors with larger amounts to invest can purchase at a reduced or zero sales charge.
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References
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