Ultra-Short-Term Funds? Steer Clear

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When bank savings and money markets pay almost nothing, it seems logical to reach for a bit more yield by taking on a smidgeon of additional risk.

Apparently lots of investors are doing just that, by moving money into ultra-short-term bond funds. Morningstar Inc. (Stock Quote: MORN), the market-tracking firm, says that “interest in ultra-short bond funds has ... been percolating.” Investors have poured about $9 billion into these funds since the start of the year, Morningstar says in a recent report.

"That’s a little surprising given the colossal blow-ups that plagued the category during the credit crisis," Morningstar adds, warning that ultra-short-term funds remain risky.

The big attraction: yields of 1% to 3%, compared to a fraction of a percent in money market mutual funds. Money market accounts, held at banks rather than fund companies, yield an average of just 0.416%, according to the BankingMyWay.com survey, while savings account yields average a mere 0.225%.

Ultra-short funds produce slightly higher yields by holding securities that carry some risk, such as corporate bonds and securities backed by assets like mortgages. In theory, risk is limited because these funds hold securities that are soon to mature, or pay back investor’s principal. That should mean their prices are not whipsawed by changes in prevailing interest rates, which can have big effects on prices of long-term bonds.

Unfortunately, many ultra-short-term bond funds were caught with lots of mortgage-backed securities in 2008, when the credit crunch hammered such holdings.

“Originally billed as one step up from money markets in both risk and reward, these funds, some of which had delved into subprime-backed and other non-agency mortgages, were among the first to feel the sting of the credit crisis,” Morningstar said.

One of the worst-hit funds was the Schwab YieldPlus (Stock Quote: SWYSX), down 44% since mid-2007. A combination of losses and investor redemptions has reduced the fund’s assets to $210 million, from a peak of $13 billion.

For the past 12 months, ultra-short funds have returned about 3.3%, making them one of the three worst-performing among the 81 Morningstar categories. Regulators and investors have accused some fund companies of misleading investors about risks.

Not all ultra-short funds have been disasters, but Morningstar still recommends steering clear of the category. It suggests some short-term rather than ultra-short-term funds, such as the Vanguard Short-Term Bond Fund Index (Stock Quote: VBISX), which yields about 3%. The fund keeps risks relatively low by holding securities maturing in less than three years. Another Morningstar pick is the T. Rowe Price Short-Term Bond fund (Stock Quote: PRWBX), yielding 3.7%.

Keep in mind, however, that generous yields can be offset if a fund’s share price falls, which can happen if interest rates or inflation rise.

Investors who can’t stomach risk may be better off with old-fashioned certificates of deposit. Yields on 24-month CDs average about 1.5%, according to the BankingMyWay.com survey. The search tool shows some even better deals, such as the 2.27% on 24-month CDs from Ally Bank. Some credit unions pay 2.5%.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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