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Don't settle for minuscule money-market returns
Ultrashort bond funds offer higher yields and only marginally more risk than money-market funds, which deliver less than 1% these days. Here's how to find the best of the ultrashort bunch.
By Timothy Middleton
Its time to look at your money-market fund as carefully as youd examine your high-tech fund. Interest rates are so low the yields of some money markets would be negative if their sponsors werent waiving expenses.
The average money market was yielding an annual rate of 0.77% as of Feb. 25, which was the lowest theyve been in their 31-year history, says Peter Crane, managing editor of iMoneyNet, which tracks the industry. Whats more, he says, the market is flat for as far as the eye can see. Were not expecting rates to go up.
After looking under the hood of your Ford, take a glance at that Lexus next to it -- that ultrashort bond fund, which offers much higher yields with only a small increase in risk.
For instance, Eclipse Ultra Short Duration (ECUIX), the No. 1 fund of its type according to MSN Moneys deluxe fund screener, was yielding an annual rate of 1.34% at January's end. "Compared to a money market, thats fabulous, says Joan Sabella, who co-manages the fund.
But before you act, look hard at the money market you already have and the short bond fund you might want. With rates so low, youve got to pinch pennies hard, which means shopping for the lowest possible expense ratio. And youve also got to pull hard on the reins of risk, because the point of this rodeo is protecting your capital.
Money markets invest in high-quality, short-term debt that's issued by the federal government and blue-chip corporations. They're managed to preserve capital, hewing to a net asset value that is always $1. Ultrashort bond funds, meantime, invest in debt thats just as good in quality, but matures in months rather than days. Preservation of capital is important, but they're slightly vulnerable to changing interest rates.
Look out for some share classes
According to Crane, the average money-market fund charges 0.44% in annual expenses, or 44 cents per $100. But some charge far more, notably Class B and Class C shares of broker-sold funds.
To keep their yields positive, many high-cost funds are waiving expenses temporarily. Among funds targeted at individual investors, 10 of the 20 best-performing funds in January were waiving expenses, according to iMoneyNets Money Fund Report.
Pressure on money funds is so intense that some investors worry their fund will break the buck, or return less than every dollar invested. Standard & Poors shares their concern.
If Im a money-fund manager and want to remain competitive, I might start looking out for something that offers a higher yield, and typically when you get a higher yield, you get higher risk, says Gary R. Arne, chief quality officer of fund ratings and research for S&P Investment Services.
This month S&P announced changes in its rating criteria for money funds intended to close a regulatory loophole covering what are called illiquid securities, which include repurchase agreements and other financial derivatives. Funds are allowed to hold up to 10% of their assets in such securities, but S&P says some funds are exceeding that limit by mislabeling some of their holdings.
Crane pooh-poohs the idea that money funds will break the buck, but he says its possible they will begin to charge shareholder fees, analogous to those charged by banks on checking accounts. Nobody talks about banks breaking the buck, he says. Investors may have to pay for the privilege of holding open the account.
Not a real difference
This is, of course, a distinction without a difference -- your money-fund dollar could become less than a dollar. This is most likely to happen at high-expense funds. If your money markets expense ratio is higher than 0.5% or so, shop for a swap.
The securities were talking about here are money-market funds, which are offered by brokerage firms and aren't guaranteed by the Federal Deposit Insurance Corp. Rival accounts, which are guaranteed, are called money-market deposit accounts, and they are offered by commercial banks.
Traditionally MMDAs, as they are called, yielded a pittance and could be safely ignored by investors. As money market rates have plunged, however, banks have stuck to their sub-1% yields and suddenly become extremely competitive.
These bank products are where all the money is going, says Crane. Their assets were up $400 billion last year, while assets of money funds were marginally lower.
But unless your broker is your bank -- and overall, banks haven't distinguished themselves as investment managers -- you're stuck with the brokerage variety of money funds for your spare portfolio cash. If you want higher yields, look into short-duration bond funds.
Duration is the definition of interest-rate risk in bonds. It is analogous, but not identical, to maturity. One Group Ultra Short-Term Bond I (HLGFX), another top-drawer fund, has an average effective maturity of its holdings of 2.5 years, but a duration of 0.7 years.
The formula by which interest-rate risk is determined is duration times the change in rates. If rates were to rise one percentage point, the principal value of the One Group fund would decline 0.7%.
Higher risk
At a typical high-quality bond fund, the risk is much higher because duration is greater. The average intermediate-term fund has a duration of 4.2 years, meaning that same one-point rate hike would drain the portfolio of 4.2% of its value.
At a long-term fund, the risk is 6.5 years, or 6.5% against a one-point rate hike. Only the shortest-duration bond funds, obviously, are a suitable substitute for a money-market fund.
These duration numbers, by the way, are statistical estimates and no guarantee a fund will experience precisely the results they predict. So in addition to duration, take a look at a short-term bond funds standard deviation, which is a measure of price fluctuation based on its actual performance.
How to find the best ultrashort funds? Here are the criteria I believe are most important:- Manager tenure of at least three years, and the longer the better. You want to be sure the current management has produced the funds track record, not somebody else. The managers of the top 10 funds turned up by our screener have held their posts an average of more than eight years.
- An expense ratio as low as possible. Among the top 10 funds identified by MSN Moneys screener, the average ratio was 0.448%.
- Standard deviation as low as possible. The whole idea of a money fund-proxy is stability of capital.
- Five-year returns as high as possible. Such a relatively lengthy horizon is needed to weed out funds that have been hot lately, but not consistently. Managers Short Duration Government Fund (MGSDX has been on a tear the last three years because it invests in mortgage-backed bonds. But that marketplace is bound to cool.
Seeking a surrogate
Some nervous investors are interested in short-bond funds not as a surrogate for cash, but as a surrogate for other bonds, because higher interest rates at some point are all but inevitable.
Now is not a good time to buy bonds, but knowing what is coming (it) makes sense to buy short-duration bonds like Strong Ultra-Short (STADX) or Vanguard Short-Term Corporate (VFSTX), says a member of MSN Start Investing community who uses the screen name "Boss 215". You could experience some price fluctuation, but nothing like long term bonds, he adds.
Hes right about that (and his recommendations are right-on, as well). Long-term bond funds are of interest mostly to speculators, and then only when rates are falling. Investors get most of the returns of long bonds in an intermediate-term fund with much less interest-rate risk.
Whatever flavor of bond fund you like, the harsh reality is that a 20-year bull market in bonds is ending, and future returns are likely to come from the coupon, not capital appreciation. Coupons on ultrashort bonds deliver between 1% and 1.5% per year, and that could be the funds total return in the next year.
Could be worse -- as in a money market.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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