Short-Term Bond Funds vs. Cash

Investors seeking yield on short-term savings face a choice: hold cash in high-yield savings accounts and money market funds, or invest in short-term bond funds for potentially higher returns. The decision hinges on understanding duration risk, interest rate sensitivity, and the specific conditions that favor each approach.

The 2022 bond market provided a stark lesson. Rising interest rates caused short-term Treasury bond ETFs to lose 3% to 5% while money market funds gained 1% to 2%. Investors expecting bonds to always beat cash learned otherwise.

Understanding Duration Risk

Duration measures a bond fund's sensitivity to interest rate changes. A fund with a duration of 2 years will decline approximately 2% in price for every 1 percentage point increase in interest rates. Conversely, it will gain 2% for every 1 percentage point rate decline.

Short-term bond funds typically have durations between 1 and 3 years. Ultra-short bond funds maintain durations under 1 year. Money market funds and savings accounts have durations near zero—their yields adjust to rate changes without affecting principal.

This distinction matters in rising rate environments. When the Federal Reserve increased rates from 0.25% to 5.50% during 2022-2023, bonds with any meaningful duration suffered price declines. Cash instruments benefited from higher rates without principal loss.

The 2022 Case Study

Examining 2022 returns illustrates the duration risk:

Vanguard Short-Term Treasury ETF (VGSH): Duration approximately 1.9 years. Total return for 2022: -3.8%.

iShares 1-3 Year Treasury Bond ETF (SHY): Duration approximately 1.8 years. Total return for 2022: -3.5%.

Vanguard Ultra-Short Bond ETF (VUSB): Duration approximately 0.9 years. Total return for 2022: -0.7%.

Fidelity Government Money Market Fund (SPAXX): 2022 return: approximately +1.5%.

An investor holding $100,000 in VGSH lost $3,800 in 2022 while a money market investor gained $1,500. The $5,300 difference represents a significant cost for choosing short-term bonds over cash during a rising rate cycle.

When Short-Term Bonds Outperform

Short-term bonds typically beat cash in three scenarios:

Falling Interest Rates

When rates decline, bond prices rise. A short-term bond fund with a 2-year duration gains approximately 2% in price for each 1% rate drop, plus it continues earning coupon income. Cash yields simply decline with no price appreciation.

During 2019, as the Fed cut rates from 2.50% to 1.75%, short-term Treasury funds gained 4% to 5% while money market yields fell from 2.5% toward 1.5%.

Steep Yield Curves

When the yield curve slopes upward steeply—meaning longer-term bonds yield significantly more than cash—investors earn a "term premium" for holding short-term bonds rather than cash. If 2-year Treasuries yield 4.5% and money markets yield 3.5%, the 1% premium may compensate for duration risk.

However, yield curves can invert, eliminating or reversing this premium. Throughout 2023-2024, short-term Treasury yields exceeded long-term yields, providing no compensation for taking duration risk.

Stable Rate Environments

When rates remain unchanged for extended periods, short-term bonds earn their yield with minimal price volatility. The higher coupon compared to cash accumulates without the offsetting price declines that accompany rising rates.

When Cash Outperforms

Cash beats short-term bonds under these conditions:

Rising Interest Rates

As demonstrated in 2022, rate increases cause bond price declines. Duration risk works against investors. The higher yield on bonds cannot compensate for principal losses when rates rise quickly or significantly.

A bond fund yielding 3% with a 2-year duration loses roughly 2% in price for each 1% rate increase. If rates rise 2% over a year, the fund loses 4% in price while earning 3% in income, netting -1%. Meanwhile, cash yields rise with rates, earning perhaps 2% to 4% depending on timing.

Inverted Yield Curves

When short-term rates exceed long-term rates, cash often yields as much as or more than short-term bonds. Taking duration risk without additional yield makes little sense. During inversions, money market funds may yield 5.3% while 2-year Treasuries yield 4.5%—cash pays more with less risk.

Short Time Horizons

For money needed within 6 to 12 months, the price volatility of short-term bond funds introduces unnecessary risk. Even modest declines can reduce returns below what cash would have provided. Emergency funds and near-term savings goals generally belong in cash equivalents.

Yield Comparison: Current Environment

As of late 2024, the rate environment includes:

• Money market funds: 4.75% to 5.25% yields
• Ultra-short bond funds: 5.00% to 5.50% yields
• Short-term Treasury ETFs: 4.50% to 5.00% yields (current yield, not total return)
• 2-year Treasury notes: approximately 4.25% yield

The inverted curve means ultra-short and money market instruments currently yield more than slightly longer short-term bonds. This environment favors cash over short-term bonds for most purposes.

When the Fed eventually cuts rates, this calculus will shift. Lower money market yields combined with bond price appreciation could favor short-term bond funds. Timing this transition proves difficult.

Credit Risk Considerations

Beyond duration risk, some short-term bond funds include credit risk:

Government-only funds: Invest exclusively in Treasuries and agency securities. No credit risk beyond U.S. government default.

Investment-grade corporate short-term funds: Include corporate bonds rated BBB or higher. Credit spreads can widen during market stress, causing price declines beyond those from rate changes.

Prime money market funds: Hold commercial paper and short-term corporate debt. Generally stable but can experience stress during financial crises (as in 2008).

For near-cash holdings, government-only options minimize complexity. The small yield premium from corporate credit exposure rarely compensates for the additional risk in what should be the safest portion of a portfolio.

Tax-Efficiency Differences

Short-term bond funds may offer tax advantages over money market funds in certain situations:

Capital loss harvesting: Bond fund losses can offset capital gains elsewhere in a portfolio. Money market funds maintain stable $1.00 NAVs and generate no capital gains or losses.

Treasury interest: Funds holding Treasury securities pay interest exempt from state income taxes. This benefits investors in high-tax states. Both Treasury money market funds and short-term Treasury bond funds offer this exemption.

Timing of income: Bond fund income may include both coupon payments and price changes. Tax timing can differ from money market funds that accrue interest daily.

For taxable accounts, comparing after-tax yields matters more than pre-tax yields.

Building a Short-Term Allocation

Investors with significant short-term holdings might segment their cash:

Tier 1 - Immediate (0-3 months of expenses): FDIC-insured savings or money market funds. No duration risk. Instant access.

Tier 2 - Near-term (3-12 months): Ultra-short bond funds or additional money market holdings. Minimal duration risk (under 1 year). Preserves flexibility.

Tier 3 - Intermediate (1-3 years): Short-term bond funds appropriate if funds won't be needed urgently. Accept modest duration risk for potentially higher returns over the holding period.

This tiered approach matches investment characteristics to spending timelines. Money needed soon stays in cash; money with longer horizons can accept limited duration risk.

Evaluating Trade-Offs

The decision framework for short-term bonds versus cash:

Choose cash when:

• Funds may be needed within 12 months
• Interest rates are rising or expected to rise
• The yield curve is flat or inverted
• You prioritize principal stability over potential extra returns

Consider short-term bonds when:

• Holding period exceeds 1 to 2 years
• Interest rates are falling or stable
• A steep yield curve provides meaningful term premium
• You can tolerate 2% to 4% annual volatility for potentially higher returns

Neither choice is universally superior. The optimal selection depends on rate environment, holding period, and risk tolerance.

Checklist for Short-Term Holdings Decisions

• Determine your time horizon and when you will need access to the funds
• Compare current money market yields to short-term bond fund yields; if similar, favor cash
• Check the yield curve slope; inverted curves favor cash, steep curves may favor short-term bonds
• Assess the interest rate outlook and whether the Fed is likely raising, cutting, or holding rates
• Match your selection to your risk tolerance, recognizing short-term bond funds can lose 2% to 5% in adverse years