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%.

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.

"Even though the economy has been soft, corporate profitability has been quite good," he says. "The valuations of corporate bonds are compelling."

To obtain a bit more yield than ultra-short funds pay, consider short-term bond funds. These focus on securities with maturities of up to five years. A top choice is T. Rowe Price Short-Term Bond ( PRWBX), which yields 2.40%. During the past five years, the fund returned 4.3% annually and outdid 71% of competitors.

Convinced that corporate balance sheets remain sound, portfolio manager Ted Wiese has been increasing his allocation to corporate bonds. The fund now has 51% of issues in corporate issues. Wiese has been buying some bonds known as crossover issues. These have been rated BBB by one rating agency and BB -- or below investment grade -- by another agency. He aims to buy such bonds when their financial picture is improving and the securities seem likely to be upgraded.

A favorite crossover holding is an issue from Boston Scientific (BSX), a maker of medical devices. "It is an improving credit in a growth industry," Wiese says.

Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.

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