Investors have fled bonds of all kinds since mid-June—and even one of the fixed-income market’s safest corners – short-term investment-grade bond funds – hasn’t been immune.

July 5, 2013, 6:09 p.m. ET

‘Safer’ Short-Term Bond Funds See Outflows

DAISY MAXEY

Investors have fled bonds of all kinds since mid-June—and even one of the fixed-income market’s safest corners hasn’t been immune. According to preliminary data from mutual-fund tracker Lipper, in the week ended June 26 investors pulled a net $126 million out of the short-term investment-grade bond funds that have reported so far. That brings those funds’ assets to $77 billion. Unless that number changes, the week would be the first time the category saw more money leave than come in since November 2011. Until the end of May, short-term investment-grade bond funds were the bond market’s defensive darlings. This year through May, according to Lipper, investors poured $12.7 billion into the funds, which buy bonds with a relatively low risk of default that mature within one to three years. Because they mature soon, short-term bonds are less vulnerable to interest-rate increases, which drive down bond prices. For that reason, many investors had moved assets from intermediate- and long-duration funds to short-duration funds. But when Federal Reserve officials signaled in mid-June that the central bank might taper its bond buying later this year, investors pulled billions of dollars out of bond funds—and even short-term bond funds were hit.Jeff Tjornehoj, a senior research analyst at Lipper, says he wouldn’t be surprised to see the selling continue.

“Financial advisers and investors are showing some concern around recent losses,” Mr. Tjornehoj says.

New York-based Altfest Personal Wealth Management, which manages $911 million, has shifted some money from short-term funds to municipal bonds, where yields are more attractive, says Gregory Lavine, a senior financial adviser at the firm.

When the Federal Reserve begins to raise interest rates, which bank officials have said could happen in 2015, the prices of some short-term bond funds could drop rapidly, Mr. Lavine says.

Short-term bond funds have lost 0.55% on average this year, but still are up 1.1% in the 12 months through July 3, according to investment research firm Morningstar.

But if and when interest rates increase, the prices of such funds could drop by 2% to 3%, Mr. Lavine says.

“We don’t think it’s a place to be overweight if it’s your safe money,” he says.

Still, the bond fund market offers few other options for price stability.

Brian Goodstadt, an investment adviser at Paragon Capital Management in Denver, has a small position in the RiverPark Short Term High Yield Fund, which invests in short-term high-yield bonds and has an expense ratio of 1.25%, or $125 per $10,000 invested. The fund yields 3.6%, and Mr. Goodstadt says he expects short-term fixed-income funds “will just get hit less” than a long-duration fund if rates rise.

Chad Carlson, an adviser at Balasa Dinverno Foltz, invests client money in theVanguard Limited-Term Tax-Exempt Fund, which yields 0.83% and costs 0.12%. The fund has a duration of about 2.3 years, which means that if rates rise one percentage point, the fund would lose roughly 2.3%.

“We’re getting paid to take some risk, but the interest rate is not where we’re getting paid a lot to take that risk,” says Mr. Carlson, whose Itasca, Ill., firm manages $2.4 billion.

The Vanguard Limited-Term Tax-Exempt Fund has lost 0.47% this year, but gained 0.35% over the 12 months ended July 3, according to Morningstar.

“We’re very aware that our clients aren’t used to losing money on bonds,” Mr. Carlson says. “That’s supposed to be the defensive part [of the portfolio], and that hasn’t been the case in the last month and a half.”