Bond funds that are all about defense



The article appeared in the September 2021 issue of Morningstar Fund Investor. Download a free copy of Investor Fund through site visit.

The outlook for investors seeking income in the relative safety of the Morningstar Ultra-Short Bond category has been mixed in recent years. Much of this is on purpose, as the very characteristics that make ultra-short bond funds attractive both in rocky credit markets and in rising rate environments also dampen their returns.

Investors may be attracted to ultra-short bond funds for a number of reasons. In an age when most savings and money market accounts have yielded close to zero for a number of years, the extra yield offered by an ultra-short “cash plus” bond fund could be attractive to the investor at. looking for a place to store money for a period of time. On the flip side, with many mid-grade core bond funds posting durations approaching multi-decade highs, investors interested in broad fixed income exposure may be drawn to an ultrashort bond fund. simply to reduce their interest rate risk. While investors remain aware of the distinct profiles of these funds compared to and among other fixed income funds, ultra-short bond funds can be valuable portfolio building blocks in various market environments.

Ultra-short bond funds invest primarily in high-quality securities (although some invest modestly in high-yield debt securities) and have an effective maturity, a measure of interest rate risk, of 25% or less of the rate. three-year average effective maturity of the bond Morningstar Core Bond Index. In practice, most ultra-short funds have maturities of less than one year and prove to be much more resilient in rising rate environments than their counterparts higher on the maturity scale. When yields soared in the first quarter of 2021, the average mid-level core bond fund was down 2.9%, while the mid-size ultra-short bond fund gained 0.2%.

While super-short bond funds are also defensive in rocky credit markets, the degree of variability here is greater and depends on how each portfolio manager approaches positioning. While many super-short-term bond funds invest almost entirely in high-quality US Treasuries, high-quality agency and corporate mortgages, some raise the bar higher with high-yield bonds, corporate debt. emerging markets and esoteric securitized credit. This can help increase yield, but can also cause pain when slowing down. The pandemic-related massive sell-off from February 20, 2020 to March 23, 2020 saw the Medium Ultrashort strategy show a loss of 2.9%, lower than the declines experienced by longer-term and lower-credit-quality strategies, but still a big shock to those who see their ultrashort allocations as a ballast, or even an outright cash surrogate, within their larger portfolios.

Two ultra-short bond strategies illustrate the relative risk and rewards of the category: Fidelity Conservative Income Bond (FCONX) and Pimco in the short term (PSHAX). Both have earned Bronze Morningstar Analyst Ratings for their judicious investment processes, experienced managers, and strong support resources, but they offer different risk profiles. The Fidelity Fund is a cash substitute that focuses almost exclusively on corporate and investment grade US Treasuries, while the Pimco Fund has turned to high yield credit, emerging markets and derivatives to obtain an advantage.

In the largely credit risk-friendly market of the past decade, Pimco’s short-term tactic has won: its 1.7% 10-year annualized return to September 2021 has exceeded the 1.1% return on Fidelity Conservative Income Bond. But the Fidelity fund remains an attractive option when credit markets collapse: in 2020 from February 20 to March 23, it lost a modest 1.9%, while Pimco Short-Term fell 3.7%.

Choosing between these two ultrashort bond funds, not to mention the larger category universe, depends on what you need from your ultrashort bond fund. Investors who are looking for a true “cash-plus” vehicle and are willing to forgo income potential may wish to stick with a fund like Fidelity Conservative Income Bond. Those who focus on the resilience of an ultrashort bond fund to interest rate shocks and don’t fear a bit more volatility may prefer Pimco Short-Term.

Disclosure: Morningstar, Inc. licenses financial institutions as tracking indexes for investment products, such as exchange-traded funds, sponsored by the financial institution. License fees for such use are paid by the sponsoring financial institution based primarily on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division market, sell, or make any representation regarding the advisability of investing in any investment product that tracks a Morningstar Index.



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