Short-Term Bond Funds for Emergency Fund Money

A reader writes in, asking:

“I currently have my emergency fund in an online savings account. What would you think about transferring it to Vanguard’s Short-Term Tax Exempt Fund to increase my after-tax return or to the new Short-Term Inflation-Protected Securities Index Fund to make sure it keeps up with inflation?

I understand that my principal will not be FDIC insured. But just how high is the additional risk in either case?”

Credit Risk

In terms of credit risk, the tax-exempt fund is certainly riskier than a savings account or the Short-Term Inflation-Protected Securities fund, given that a savings account is FDIC insured and the TIPS fund will hold bonds backed by the Federal government.

That said, default risk is still very low for the Vanguard Short-Term Tax-Exempt Fund. It holds highly-rated bonds, with very short maturities. (More than 80% of the holdings have maturities shorter than 3 years, and more than half have maturities shorter than 6 months.)

Inflation Risk

With interest rates where they are right now (-1.42% inflation-adjusted yield for 5-year TIPS), the short-term TIPS fund won’t keep up with inflation — at least not in the near or intermediate-term future. But the advantage of the TIPS fund is that you know it won’t lag inflation by too much.

In contrast, anything denominated in nominal terms (such as a savings account or the Short-Term Tax-Exempt fund) could fall well behind inflation — though they each have less inflation risk than longer-term nominal bond funds.

Interest Rate Risk

Both of the funds in question would be subject to interest rate risk. That is, when market interest rates go up, the price of each fund will go down.

With an average duration of 1.2 years, the Short-Term Tax-Exempt fund has a pretty low degree of exposure to interest rate risk. For each 1% that applicable interest rates rise, the price of the fund would fall by just 1.2% (roughly).

The Short-Term Inflation-Protected Securities fund will track an index that currently has an average duration of 2.7 years. However, it’s worth noting that this is not an apples-to-apples comparison with the Short-Term Tax-Exempt fund, because the price of the TIPS fund will only move in response to changes in real (inflation-adjusted) interest rates. For example, if nominal interest rates rise by 2% solely because expected inflation has increased, the price of a TIPS fund wouldn’t budge, whereas the price of a nominal bond fund would fall.

Modest Allocations Could Make Sense

For money specifically designated as an emergency fund, I think it’s important to keep a good portion of it in something that is liquid and which will not fluctuate in value. But, if you have, for example, an emergency fund with 12 months’ worth of expenses, I don’t think it’s necessarily a bad idea to take on a bit of extra risk with some of that money.

• If you’re particularly concerned about inflation, allocating a portion to short-term TIPS would be perfectly reasonable, or
• If your emergency fund is located in a taxable account and you’re looking to take on a modest amount of risk for slightly higher after-tax returns, allocating a portion to short-term tax-exempt bonds could be perfectly reasonable as well.