Ultra-short bond funds have become popular because they offer higher yields than money market funds -- their portfolios contain higher-coupon bonds that are about to mature. Depending on the fund specifications, the portfolios can contain Treasury, government agency, mortgage-backed and corporate bonds that will mature within 12 months. These funds are appropriate for the same people and institutions that invest in money market funds, provided those investors are aware of the risk involved.
Money Market Funds
Money market mutual funds invest in securities that are issued with maturities of 12 months or shorter. These securities include U.S. Treasury bills, bank certificates of deposit, commercial paper, banker's acceptances and repurchase agreements. Those money market funds that invest in only government-guaranteed securities, such as T-bills, are considered the most conservative and safe although all money market funds are generally considered safe investments. Individuals and institutions use these funds as repositories of money that must be kept in safe interest-earning accounts.
Ultra-Short Bond Funds
Theoretically, ultra-short bond funds are also very safe investments but, in practice, they have drawbacks not found in money market funds. During periods of very low market interest rates, many of those portfolio bonds have coupon rates higher than current interest rates. When a bond has a higher coupon rate than current interest rates, it is called a premium bond, because its price is higher than par, or the $1,000 face value of the bond. When bought into the portfolio, the higher price paid is more than the principal received at maturity, so there is principal loss if the bond is held to maturity. The higher interest payments can make up for the loss of principal, making the total return on investment higher than with money market funds. Some ultra-short funds seek higher yields available in corporate bonds or those that can be affected by economic difficulties. During the credit crisis of 2008, some ultra-short bond funds performed poorly, losing as much as 20 percent of their value.
The benefits of ultra-short bond funds include higher income from the higher coupon bonds in the portfolio. When market interest rates decline, the market values of these bonds rise in the portfolio, so they can also present opportunities for trading profits in the portfolio if sold before they mature. It is also possible for investors to trade in and out of ultra-short bond funds, because their market values rise and fall with market interest rate changes. Individuals who are trying to maximize the income from their conservative investments often use these funds. Institutions such as corporate treasury and pension funds, trust funds, investment advisers and other mutual funds that are tasked with obtaining the highest rates of return for their investors, park their money in these funds until ready to invest in longer-term bonds.
Although economic dislocations like the credit crisis of 2008 are not historically common, they do present a risk to ultra-short bond fund investors. Because of this, they can't be considered cash-equivalent investments, so individuals and institutional funds that must invest in only cash-equivalent securities would not find ultra-short bond funds appropriate.
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