Ultra-short bond funds are becoming attractive again

0

At best, funds in Morningstar’s ultra-short bond category allow investors seeking stability or those with short-term goals to outperform savings accounts or money markets for minimal additional risk. The yield part of this equation had been lacking in recent years due to ultra-low interest rates, but with rates rising in 2022, these funds look attractive again, provided investors know how to avoid the lowest options. risks from the peer group.

Here, we chronicle the resurgence of ultra-short bond funds, highlight their attributes and potential pitfalls, and end with two funds worth taking a closer look at.

Ultra-short bond funds are back

The backdrop for the return of ultra-short bond funds is the Federal Reserve’s determination to fight inflation by raising the overnight lending rate charged to member banks several times this year. These rate hikes have in turn resulted in significantly higher returns for investment horizons of one month to two years, the very range that ultra-short bond managers focus on.

Indeed, between the end of 2021 and July 25, 2022, US government securities yields in the one-month to two-year range increased by an average of 2.45% (or 245 basis points) , about twice the average increase for 10- to 30-year-olds. Additionally, with six-month and one-year Treasury bills now yielding more than the two- to 10-year maturities, the yield curve (a linear plot of each security’s yield against its maturity at any given time) s is reversed.

The jump in short-term rates has started to affect ultra-short bond funds. As of June 30, 2022, the category’s 30-day average SEC yield of 2.0% was up 131 basis points since the start of the year. And those yields will likely continue to rise as older bonds with lower coupons mature and are replaced by new issues.

A conservative category

The better returns haven’t prevented most ultra-short bond funds from posting modest year-to-date losses, but they have fared much better than their equities as well as their mid- to long-term bond counterparts. It is by design. Ultra-short strategies invest primarily in higher-quality issues (although some invest modestly in high-yield debt), can be assigned to a variety of sectors, and have durations of less than a year, a measure of sensitivity to interest rate. [1]

Given this profile, these funds typically outperform other bond funds in times of rising rates and choppy credit markets. This was also true when yields soared in the first quarter of 2021, for example. The average ultra-short bond fund then posted a 0.2% gain, while most other bond issues posted a loss.

Pay attention to credit risk

Nonetheless, some funds in this space may be more adventurous with respect to credit risk and therefore may be subject to unwanted surprises when the markets turn. In the coronavirus-related market turmoil in March 2020, a small number of funds that had taken on additional credit risk, with higher allocations to risky debt and/or securitized credit, experienced much higher losses. than the category standard. Going back further, some ultra-short funds suffered huge losses during the 2008 global financial crisis, when securitized markets seized up.

Investors looking to use an ultrashort fund as a low-risk investment should avoid the highest yielding funds in the category, as the extra yield often comes at the cost of lowering their credit quality profile. While the typical ultra-short bond fund held around 1% of its assets in below-investment-grade issues in June 2022, around a dozen offerings held a stake north of 5%. A large unrated exposure can be another warning sign. Although the lack of a credit rating on a bond is not necessarily a sign of high risk, these issues are generally considered less liquid, which can lead to problems during periods of market turbulence.

Beware of interest rate risk

Not all ultra-short offerings take the same interest rate risk either. In June 2022, the typical ultra-short bond fund had a duration of six months, but the spectrum ranged from funds with a duration close to zero to those with a duration north of one year. Taking on more interest rate risk can be another way to increase a fund’s return. Funds with higher interest rate sensitivity fare worse during periods of rising rates, so it’s important to be aware of this if you’re looking for an ultra-short fund as a safe haven.

Two funds worth looking at

Here are two ultra-short offerings that avoid the main pitfalls of the asset class, but nevertheless have slightly different risk profiles.

Fidelity Conservative Income Bonds (FCNVX), which has a Morningstar Silver analyst rating, is the more conservative of the two. It positions itself as an enhanced liquidity offering with more flexibility than a money market fund, but not to the point of getting into trouble. The strategy’s experienced management team proved adept at striking this balance through a cautious approach. The team focuses exclusively on investment grade bonds, limits BBB-rated issues to 5% of assets and avoids securitized credit. The portfolio’s conservative posture consistently shows, as in its June 2022 SEC yield and duration measures of 1.53% and 0.1 years, respectively, well below the corresponding category norms. While the strategy’s defensive tact leaves it behind most of its ultra-short bond class counterparts for long periods when the market rewards risk taking, it has posted strong relative results in periods of stress, such as the first quarter of 2020 and the first half of 2022.

Gold rated Pimco Short Asset Investment (PAIDX) adopts a risk profile closer to that of its typical ultrashort bond competitor. As of June 2022, its SEC yield of 2.0% and duration of 0.4 years were roughly in line with the norms for the respective category. Lead manager Jerome Schneider and his well-resourced team are focused on capital preservation by maintaining a high degree of liquidity, minimizing volatility and avoiding below investment grade debt. Corporate credit, securitized debt and US Treasuries generally make up the bulk of the fund’s assets. While the strategy performed slightly worse than its typical counterpart at the start of 2020, its returns in difficult areas were mostly on par with the norm and its Sharpe ratio, a measure of risk-adjusted return, ranked in the top third of the category since its inception from June 2012 to June 2022.

The right ultrashort offer ultimately comes down to an individual’s needs and broader wallet. However, the most reliable options in the category, like the two we discussed, combine a higher quality credit profile, often signaled by moderate or lower yields compared to their peers, with modest fees. Investors will rarely go wrong when choosing ultra-short options with these attributes.

[1] Each year of duration results in an additional 1% loss (gain) for each 1% increase (decrease) in interest rates. If interest rates rise by 1%, for example, a bond fund with a one-year duration should lose about 1%, while a bond fund with a five-year duration should lose about 5%.

Share.

Comments are closed.