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.