Short Term, Low Risk, High Returns? Tall Order

We're looking to buy a house in a year. Do you have any suggestions for a short-term, low-risk investment that might also give us 5% to 7% in returns?

Question: My wife and I have about $25,000 to invest. We just moved it out of a CD that matured, and it's now sitting in a savings account that's earning 1.99%. We're going to be buying a house in another year so we don't want to tie up the money for longer than that. But we also need something relatively safe so as to not lose principal. Do you have any suggestions for a short-term, not-so-risky investment? I was also hoping to get something around a 5% to 7% return.

— Anonymous


Answer: A short-term, low-risk investment with 5% to 7% returns? Unfortunately, even in boom times that's tough to come by. You can't get those kinds of returns without incurring some risk. And you're right: Since this is money you'll need in just one year, what you should be focusing on is preservation of principal, advises Mari Adam, a certified financial planner in Boca Raton, Fla. Unfortunately, you'll have to sacrifice some returns for the sake of safety. Your best bet? An ultrashort bond fund, which will give you the best returns with the lowest risk during your short investment horizon.

Even though they're known as conservative investments, bonds don't come without some risk. So you should start by boning up on the basics of how bonds behave. With bonds, you'll want to keep your eye on two things: the quality of the debt and the length of the maturity. First, debt quality. Since you're looking for an investment that safeguards your principal, you'll want government-issued debt or high-quality corporate issues.

Second, maturity. In order to minimize the risk, you'll want to stick with shorter-term bonds, something you were looking for anyway, says Don Cassidy, senior research analyst at Lipper.

A conservative ultrashort-term bond fund, with an average credit rating of AA, and bond maturities typically of one year or less, could fit the bill on both counts. These funds, which may hold government or corporate securities, will beat the yields on money-market funds but have less risk than bond funds with longer maturities. Right now, ultrashort funds are averaging one-year returns of 3.82%, according to Morningstar.

Why is shorter better? In the fixed-income world, the longer the maturity, the higher the risk, since investors are leaving their money tied up in one investment for a longer period of time. Bonds with longer maturities also respond more dramatically to interest rate changes than bonds with shorter maturities. And as we discussed last week, interest rates are expected to rise in the coming year. When interest rates rise, bond prices fall, so any upward rate movement could eat into your returns.

If you decide that an ultrashort-term bond fund sounds good, Adam advises you further minimize your risk by looking for funds that performed well in 1994, a year in which the Fed increased rates by 1.75 points. While that isn't the last time rates were on the rise, it was the most dramatic increase in recent memory. And if a bond fund was able to produce positive returns that year, chances are it'll do well this year, when modest rate increases are predicted. According to Morningstar, Managers Short Duration Government fund (MGSDX), FFTW U.S. Short-Term fund (FFSTX) and SSgA Yield Plus fund (SSYPX) were among the top-performing ultrashort funds that year. You'll also want to minimize your costs by looking for funds with low expenses and no transaction fees. Our fund finder can help.