Short-Term Bond Safety

• Short-term bonds typically mature in one to three years. When interest rates rise, bond prices fall, but if you hold your bonds to maturity, you get back the full face value. It is obviously easier for most people to wait one to three years to get their money back than 10 or 20, which would be the case with longer-term bonds in a rising interest rate environment. From that standpoint, short-term bonds carry less risk because as a bond nears maturity, it becomes less interest-rate sensitive, because it will soon be redeemed at par, or face value.
  
  

Short-Term Bond Funds Have No Maturity

• If you buy a one- to three-year bond and hold it to maturity, you get back the full face value. But bond funds have no maturity dates, because they constantly buy and sell bonds in their portfolios. Because of that feature, there is no guarantee that you will get your money back even in a short-term bond fund.
  
  

Premium Risk

• Bonds in the secondary market may trade for more or less than their face value -- at a premium or at a discount. When interest rates are low, most bonds trade at a premium. The premium disappears at maturity or when interest rates rise, because the maximum an investor can get back is the face value. If your short-term bond fund bought bonds at a premium, at maturity it will result in a capital loss.
  
  

Interest Rate Risk

• The risk of keeping emergency funds in a short-term bond fund is not so much in the day-to-day fund share price fluctuation, which is usually insignificant, as in the possibility of an interest rate reversal and subsequent rise. Interest rates move in trends, so when falling interest rates reverse and start rising, it may develop into a multi-year trend during which bond prices steadily decline. A decline in bond prices can wipe out several years of interest income from prior years. Since you don't know when it is going to happen, you subject yourself to a constant risk of financial loss by keeping your emergency funds in short-term bonds -- the probability of that risk may be low, but it's always there.
  
  

False Sense of Security

• Investors who ride a multi-year falling interest rates trend may point to their steady short-term bond fund total returns as proof that their holdings are safe. But if interest rates start rising, that historic performance will be no guarantee against the losses that you could sustain going forward.