By Rachel Koning Beals

Diversity is key amid yield drought and Fed-induced volatility

Historically low rates hurt investors hoping to squeeze a little yield out of a short-term stash -- the cash they might need to tap sooner versus later.

Ultra-short bond funds, generally considered to be slightly riskier and more opportunistic than money markets or the mattress, showed pluck after the 2008 credit market fallout, but the years since have proven more volatile. Year-to-date performance so far in 2011 is lagging the broader bond fund category, but some financial advisers still see an effective short-term investment opportunity lurking within carefully selected bond funds, especially compared with other short-term options. The category looks attractive once short-term interest rates begin to push higher. Preserving slim yields with low fund expenses is the key.

Interest rates across the yield curve remain extremely low. Now, the Federal Reserve has dusted off a policy last seen nearly 50 years ago with hopes of pushing longer-term rates down even further by driving up short-term rates in a bond swap.

Treasury yields and prices move inversely, so when stronger demand pushes up bond prices, yields -- and interest rates -- fall. The opposite is true as well: Weaker demand for certain notes or bonds depresses prices and yields rise. Keep in mind, weaker pricing in the short-term nicks current fund returns but may mark an attractive point of entry.

The Fed's $400 billion plan, nicknamed "Operation Twist" by Wall Street in a nod to the popular dance and a similar central bank policy move in the 1960s, is meant to drive down longer-term interest rates. But some Fed members defected and voted no to the plan to "twist" the yield curve, worried about inflation risks. Apparently, financial markets remain doubtful the Fed will be immediately successful in reviving the economy -- financial markets plunged in the wake of the bank's move. The inclusion of more 30-year bonds than was anticipated left financial markets with the feeling that the economic outlook is quite a bit worse than it had been when the policymakers met just a few weeks earlier. The Fed, which has already said it will keep short-term interest rates super low into 2013, cited the chance for European financial market contagion in the event of a default by Greece.

For certain, investors can't have it all; conservative bond fund positioning has carried opportunity costs, leaving money on the table as the global economy has remained stubbornly stagnant. The rest of the longer-term government bond market has logged better-than-expected returns.

Paul Jacobs, a certified financial planner and client service manager with Palisades Hudson Financial Group's Atlanta office, argues that "while yields are modest, volatility with short-term bonds (he's talking durations of about a year) is very low, and a spike in rates would not have a dramatic impact on performance."

"The Fed move might increase short-term rates, but even with that, it is extremely difficult to get more than 1 percent yield without taking on real risk," Jacobs says.

Jacobs says investors who stand to benefit from the tax break of municipal bonds might find the Vanguard Short-Term Tax-Exempt Fund (symbol: VWSTX) appealing, especially given its slim 0.2 percent management fee. It's a fund that diversifies among issuers, carries an average AA credit rating, and offers some risk diversification away from short-term bond funds that have corporate debt exposure.

Jacobs goes for more yield with floating-rate funds, including the Fidelity Floating Rate High Income Fund, for which annual expenses are 0.74 percent, almost half a percent lower than those of the average floating-rate fund.

Because the rates on the underlying loans go up when rates go up, "you win instead of lose if that happens," he says. Floating-rate loans pay higher yields but have lower credit quality, so limit them to 10 percent to 15 percent of a bond portfolio. Within those parameters, additional yield compensates investors for the added exposure to company credit health.

Proponents of fattening yield with at least some corporate debt exposure say ongoing low default rates and generally strong corporate earnings are a buffer against economic volatility.

Managers of the Calvert Ultra-Short Income Fund (CULYX) noted in an August commentary that the fund has experienced price markdowns on corporate bonds issued by Bank of America, Wachovia, JPMorgan Chase, and Mexican cement company Cemex, which have tracked equity market weakness.

"Despite the recent markdowns, we continue to believe that the financial health of these four companies is strong and that the prices of the bonds may rebound," the managers wrote.

The fund also pads yield by folding in floating-rate holdings that pay coupon rates linked to the three-month London Interbank Offered Rate (LIBOR), which climbed to 0.3 percent so far this year. With the three-month treasury bill yielding close to zero, the increase in LIBOR has caused the interest payments on the fund's floating-rate notes to climb, boosting its coupon income.

For conservative, cash-heavy investors, shorter duration could be the key as the fallout from the Fed's latest move jostles global markets. Inflation -- and stagflation -- discussions are cropping up once again. Inflation is a major drag on bond investments but is less risky for short-term instruments.

"Perhaps, the most baffling phase in the Fed's statement is how inflation 'appears to have moderated since earlier in the year.' That observation departs from reality," said Bernard Baumohl, chief global economist, at Princeton, N.J.-based Economic Outlook Group, in a commentary issued right after the Fed's release. "The latest cost of living data shows inflation has accelerated. Consumer prices, for example, both headline and core, are now at their highest level in three years on an annual basis. In fact, it has been rising virtually every month since November 2010, while economic growth the first half of the year has slowed to less than 1%. Lurking ahead therefore is not price stability, but stagflation. For the Fed to downplay inflation pressures, is just another concern we have of the central bank's latest strategy."

The Fed already spent about $2 trillion for two rounds of bond-buying designed to lower long-term interest rates, a strategy known as quantitative easing. Economists generally agree that the Fed's efforts had succeeded in preventing the downturn from deepening. Some say the Fed could try a third round of bond purchases.

"We still believe that rates have nowhere to go but up and the action of the Fed (to lower rates) is just going to make things more painful when rates eventually rise," says Jacobs, who in addition to maintaining short-term bond fund holdings is also bullish on inflation-protected treasury funds.

Here's a snapshot of the top five ultra short-term bond funds ranked by U.S. News:

PIA Short Term Securities Fund (PIASX): up 0.5 percent YTD; below-average risk for category; 0.35 percent expense ratio, below average for category.

Managers Short Duration Government Fund (MGSDX): up 0.7 percent YTD; average risk for category; 0.81 percent expense ratio, average for category.

TCW Short Term Bond Fund (TGSMX): up 0.8 percent YTD; average risk for category; 0.44 percent expense ratio, below average for category.

The Core Fund (SGBFX): up 0.1 percent YTD; below average risk for category; 0.73 percent expense ratio, average for category.

GMO Short Duration Investment Fund (GMSIX): up 0.1 percent YTD; above average risk for category; 0.2 percent expense ratio, low for category.


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