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Ultra-Short Bonds Beating Money Markets

NEW YORK ( TheStreet) -- The Federal Reserve recently announced its plans to keep short-term interest rates near zero for the next two years. That was bad news for shareholders of money market funds who will continue to receive tiny yields. To get better results, many investors should consider shifting some cash from money- market funds to ultra-short bond funds.

Of the money-market funds tracked by Crane Data, the highest-yielding choice today is Schwab Cash Reserves (SWSXX), which yields a puny 0.06%. You can do better with an ultra-short fund, such as Wells Fargo Advantage Adjustable Rate Government (EKIZX), which yields 2.27%. Make no mistake, the ultra-short funds come with more risk. But at a time when the Fed is holding down rates, the odds are high that top ultra-short funds will stay in the black for the next several years.

Before buying any ultra-short bond funds, keep in mind that they are very different from money market funds. Money markets invest in high-quality securities with average maturities of less than 60 days. Because of the cautious strategy, the money funds almost never lose principal.

Ultra-short funds hold bonds with maturities up to two or three years. If interest rates rise, bond prices can fall, and the ultra-short funds could lose money. But under the Fed's current policy, there is little chance that rates will rise until the middle of 2013.

Should you abandon money markets altogether? Not necessarily. If you need a parking place for cash that you must spend in the next 12 months, it can make sense to use a money market. That way you are certain not to lose any principal. But if you plan to hold the cash for more than a year, an ultra-short fund may be the right choice. In any given month, the share price of an ultra-short fund could sink temporarily. But if you can wait, the fund should eventually rebound.

Variety of Risk

Be aware that the ultra-short funds follow a variety of strategies. Some cautious choices stick with high-quality government securities. Other portfolios aim to boost yields by investing in lower-quality issues. During the downturn of 2008, some aggressive funds were pummeled, losing more than 10%.
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