Why Ultra Short Bond Funds are a Bad IdeaJuly 11th, 2012 by Marc Prosser
What are Ultra-Short bond funds? They are a niche product which hold bonds with an average maturity that is longer than Money Market Funds and shorter than Short-Term Bonds. The idea is that for taking on a little bit more interest rate risk than a money market fund, you will receive a moderate degree of additional yield.
Many people get confused between Money Market Funds (offered by brokerage firms) and Money Market Accounts (offered by banks). The most important difference is that Money Market Accounts are FDIC insured so you cannot lose money, and Money Market Funds are not. There is much confusion about this issue and the SEC has been making efforts to educate the public.
The confusion primarily stems from the fact that Money Market Funds always sell their shares at $1. However, the market value of the assets which a share represents can often be slightly above or below $1. Ultra-Short Bond funds are bought and sold for their actual Net Asset Value.
Money market funds must have have an average maturity of 90 days or less. The portfolios of ultra-short bond funds tend to have average maturities between 3 months and a year. By being able to buy longer dated debt, these funds are able to take advantage of the upward slope of the yield curve. The longer the maturity date, the more yield one can earn.
While this sounds good in theory, there are two problems with ultra-short bond funds:
- The “Extra-Yield” Is Eaten up by High Annual Expenses. Many ultra-short term bond funds have high annual expense ratios, typically between 0.36 and 0.80%. With Ultra-Short term funds currently yielding around 1.0%, the majority of your yield will be going towards the fund’s expenses. In some cases, after expenses the yield will be negative. According to a report by the Investment Company Institute the average money market fund only had fees of 0.25%. In other words, the average ultra-short bond fund is going to have to provide a half-percent more yield than a money market fund, just to compensate for the higher fees.
- Ultra-Short Bond Funds are risky. Unless you buy an ultra-short bond fund that exclusively holds US government debt (in which case, you will receive a lower yield), there is credit risk, a chance that bonds in the fund will default and the fund will lose value. In fact, in 2008 Schwab’s Ultra-short bond fund Schwab YieldPlus lost 35% of its value. While ultra-short term bond funds have less interest rate risk, they can be taking lots of credit risk. When you invest, you should find out the average credit quality of the bonds in the fund and make sure that the fund has average AA credit rating.
What is an investor to do with their cash to earn some extra interest? You are likely to receive the highest interest rate with the lowest risk from a bank. Funds placed in a savings account or money market accounts, offer the FDIC protection – government protection against loss of funds, no annual expense ratios, and fairly easy access to funds. And if you are willing to move your funds around every six months to take advantage of “promotional rates” interest rates are comparable to ultra-short bonds funds.