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Ultra-Short Bonds Beating Money Markets

A cautious choice is RidgeWorth U.S. Government Securities Ultra-Short Bond (SIGVX), which yields 1.37%. During the past five years, the fund returned 3.8% annually and ranked as the top-performing ultra-short fund, according to Morningstar. RidgeWorth emphasizes AAA-rated mortgage-backed securities. The high-quality issues enabled the fund to stay solidly in the black during 2008.

Portfolio manager Chad Stephens currently favors adjustable-rate mortgage securities. These represent pools of home mortgages. As homeowners make their monthly mortgage payments, the cash is passed on to investors who hold the mortgage securities. The securities are extremely safe because they are backed by the government. Stephens likes securities that have maturities of about one year and yield around 1%. In comparison, one-year Treasuries yield 0.08%.

The mortgage securities provide extra yield because they come with prepayment risk. Prepayments occur when homeowners refinance their mortgages and pay off the principal. The money is paid to the holders of the securities. To understand the risk in the current market environment, consider that mortgage securities are typically issued at a price of 100.

In recent months, interest rates have fallen. When rates decline, bond prices rise. Now the prices of many mortgage securities have risen to more than 105. The premium price presents a risk to investors. If homeowners refinance, they will only pay investors the principal of 100. As result, investors who paid premium prices could suffer losses.

To avoid prepayments, Stephens seeks mortgages where the homeowners are unlikely to refinance. A promising investment could be a pool where homeowners bought their homes in 2005 and suffered as the value of the properties declined. Refinancing such homes is difficult. "If you don't have equity in your home, it is difficult to refinance," says Stephens.

To take on a bit more credit risk, consider Wells Fargo Advantage Ultra Short-Term Income (STADX), which yields 1.33% and returned 2.0% annually during the past five years. Portfolio manager Jay Mueller currently has 57% of his assets in corporate bonds. Mueller is particularly keen on short-term bonds that are rated BBB, the lowest investment-grade rating. Those yield more than 1.20%.

During the volatile markets of recent months, prices of corporate bonds have softened, but default risk remains limited, says Mueller.

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