These funds can form Part 2 of a two-part emergency fund.
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By Christine Benz | 09-08-10 | 06:00 AM | Email Article

Investors seeking safety amid the economic and market turbulence of the past few years have found themselves between a rock and a hard place. On one hand, it's only logical to want to create a larger-than-average emergency fund in times of economic distress, particularly as job loss and steep short-term market losses loom large. Conventional wisdom holds that investors should hold three to six months' worth of living expenses in true cash, but I've recently spoken to some investors who say they're nudging that figure higher because they're worried about what the future holds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

On the other hand, yields on true cash (certificates of deposit, money market funds, and checking and savings accounts) are slim to nonexistent these days. So there's a big opportunity cost in holding a larger emergency fund than you really need.

That's partly why I've recently been suggesting that investors build a two-part emergency fund. Using such a strategy, you park Part 1 of the emergency fund in true cash. (Don't try to get too cute by reaching for extra yield; after all, this is money you can't afford to lose.) And then, if you have additional assets you'd like to safeguard, you can park them in a high-quality short-term bond fund. Granted, the yield pickup you see from such a fund may not be appreciably higher than what you're earning on your cash, but in such a yield-starved environment, every little bit counts.

With that concept in mind, I screened our database for bond funds that could function well for that second part of the emergency fund. I began by screening on the short-term bond, ultrashort-term bond, and muni-national short categories because venturing farther out on the maturity spectrum could subject the so-called safe component of investors' portfolios to undue volatility. I then screened on separate share classes of noninstitutional funds within those groups, and I also layered on a screen for no-load offerings. I'm generally agnostic about the load versus no-load question, in the view that if a commission-based broker gives an investor good advice and puts that investor in worthwhile investments, that's money well spent. But in the case of short-term bond funds, where yields are barely positive to begin with, I have a hard time getting excited about any investment that carries a sales charge.

To help home in on funds that have been less risky than their peers, I focused on funds whose bear-market rankings place them in the least-risky third of their peer groups. For bond funds, bear-market percentage ranks show how well a fund has held up in all the months during the past five years in which the Barclays Aggregate Bond Index has lost more than 1%. (As with our return rankings, a lower number is better.) And to help further winnow down the universe to funds that have a good shot at being less risky than their peers in the future, I searched for those with expense ratios of less than 0.6%, which places them in the short-term bond category's cheapest quartile. Not only does having low costs improve a fund's odds of future outperformance, but it also lessens the likelihood that a bond-fund manager will venture into overly risky investments to help make up for his built-in disadvantage versus his peers. Finally, because it's always better when a fund is run by a seasoned hand than by a newbie, I added a screen for management tenure of five years or longer.  Click here to run the screen yourself.

Several of Morningstar's favorite short-term bond funds made the cut, including the following:

 T. Rowe Price Short-Term Bond 
This  Fund Analyst Pick features everything one might look for in a sturdy short-term fund, including reasonable costs and a proven tendency to sidestep losses; senior analyst Miriam Sjoblom points out that under the 15-year watch of current manager Ted Wiese, the fund's losses in any rolling 12-month period have been minuscule. (In the fund's worst-rolling 12-month runs, it has lost less than 12 basis points.) Wiese and his crew also get kudos for working to protect this portfolio from the housing sector's calamity well in advance of other money managers. For investors in higher tax brackets, sibling  T. Rowe Price Tax-Free Short-Intermediate  beckons as a compelling pick.

 USAA Tax-Exempt Short-Term 
Like the aforementioned T. Rowe funds, this short-term muni offering doesn't do anything too fancy. Lead manager Regina Shafer keeps duration short and steady and focuses on bonds that she perceives to be mispriced. True, the fund's portfolio is lower-quality than its average peer's--Shafer holds close to 40% of assets in bonds rated BBB and below, versus just 5% for its typical category peer. That could hurt it if municipal finances continue to struggle, but the bonds' above-average yields provide something of a cushion.

 Vanguard Short-Term Bond Index 
As a result of its ultra-low costs and Vanguard's indexing prowess, this short-term bond index fund has long been on Morningstar's short list of fixed-income favorites. True, its focus on government-backed bonds at the expense of corporates may be a hindrance in a strengthening economy, when the latter will tend to hold up better than the former. But in a flight to quality like the one we observed in 2007 and 2008, this fund has held up like a champ. It's also available in exchange-traded fund form as  Vanguard Short-Term Bond ETF  . Vanguard's short-term municipal fund,  Vanguard Short-Term Tax-Exempt  , also made it through my screen.

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