How safe are short-term bond funds?

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What are we looking for?

Short-term bond mutual funds and exchange-traded funds, which are a conservative way to hold bonds in a rising rate world. But just how safe are they, and are there alternatives?

Our screen

We've ranked short-term bond funds from largest by assets on down, and include year-to-date, one-year and three-year returns. Fees are also shown because they have a big impact on returns.

What we found

A lot of investors bought bond funds in recent years to avoid the unpredictability of the stock markets and to generate stable returns. But it's clear that you can see declines even in short-term bonds, which mature in five years or less and are not as vulnerable to interest rate rises than bonds maturing further in the future.

Year-to-date losses in the Canadian short-term bond fund category are slight so far, but we could see further declines if interest rates keep climbing. Perhaps, then, an alternative approach is called for. Suggestion: Replace short-term bond funds with a special type of investment savings account that can be traded like a mutual fund.

A wide variety of firms offer these accounts, including RBC, TD, Manulife, Dundee, B2B Bank and Renaissance. The usual yield is 1.25 per cent, which is not subject to day-by-day market fluctuations like bond funds. Issuers can adjust the rates on these accounts if they want, but competition has kept returns in the current range for years now.

If the economy stalls out and interest rates move lower, short-term bond funds would offer some upside while the yield on investment savings accounts may come under downward pressure. On the other hand, if the current rise in interest rates broadens to include the short-term rates steered by the Bank of Canada, then we could see investment savings accounts paying more while bond funds of all types decline.

Investment savings accounts are typically treated like bank deposits, so they're covered for up to $100,000 by Canada Deposit Insurance Corp. While widely available, from virtually all sellers of investment products, these accounts sometimes charge redemption fees when you sell them. Inquire before buying.