They’re an 'interesting alternative' to money-market funds, but they're not without risk
As more central banks start to hike policy rates, investors are looking for investments that are relatively insulated against the associated risks without constraining themselves to cash and cash equivalents. Ultra-short bond funds, specifically those with underlying bond maturities of three years or less, are one approach.
“They can be an interesting alternative to money-market funds, because money-market funds are restrained to 13-month maturities,” Jack Ablin of Cresset Wealth Advisors told WealthManagement.com.
A quick look at the yield curve shows why going beyond the 13-month threshold is important. According to Ablin, the overnight rate as of March 29 was 1.63%; the one-year Treasury yield was at 2.09%, while the two- and three-year Treasuries had yields of 2.27% and 2.39%.
“Having the ability to move beyond 13 months in an ultra-short bond fund … makes a difference in a period where yields are so low,” Ablin said.
According to RDM Financial Group chief investment officer Michael Sheldon, investors that aren’t satisfied with money-market fund yields could venture into ultra-short bond funds, which come with “somewhat higher interest-rate volatility”. The primary risk with such funds is that increases in short-term interest rates weigh on the prices of ultra-short bond funds, which could wipe out the yield.
With that risk in mind, Ablin said clients should be willing to hold ultra-short bond funds for at least a year in order to capture higher yields than money-market funds. “If it’s money you’re looking to spend in the next few months, I would just recommend money-market funds,” he said.
Another good practice when investing in ultra-short bond funds is to scrutinize their underlying holdings. “Some have a large exposure to corporate bonds,” said Jack Riashi, a financial advisor at Bloom Asset Management. “Most of them are investment grade, but some aren’t. People have to be careful to see what bonds the funds own.”
Investors would also do well to remember that they can’t use bond funds like a cash account. That means those who tend to write checks on their funds or use money tied up in funds to buy securities directly should think twice.