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Ultra-Short Bond Funds Offer Yield and Limit Duration Risk
Monday, August 5, 2013
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The search for yield has been a persistent and vexing challenge for anyone charged with managing money. But what are the options? How far out the curve do you have to go to find suitable opportunities? And how do you balance your yield appetite with potential credit and duration risk?

One option is the ultra-short duration bond fund (mutual funds and ETFs). They generally have duration exposure of less than one year—compared to “short-term” bond funds with duration exposure of  one to three and one-half years. Ultra-short duration funds offer investors a way to enhance yield over other money market securities, while maintaining flexibility and liquidity, and limiting duration risk. Fund managers use a broad mix of primarily investment-grade assets to deliver higher income while maintaining low duration, which positions these funds to react to a rising interest rate environment. Limiting duration exposure, because it reduces price sensitivity, may also help reduce NAV volatility.

For example, asset-backed securities (ABS) and bank loans can offer tremendous opportunities for ultra-short investors: they are highly liquid, offer strong income potential, and the fundamentals are currently quite strong. Broad market acceptance of off-the-run ABS gained momentum throughout 2012, as strong demand continued to drive spreads tighter. Technical forces are also supportive of demand, as older vintage transactions continue to pay down. A reduction in outstanding ABS volume and reinvestment by investors should work together to support ABS demand and pricing throughout 2013.

Likewise, strong inflows into the bank loan sector suggest that investors are finally beginning to appreciate its tremendous value proposition. Secured bank loans offer seniority in the capital structure, secured status, and financial maintenance covenants. They also offer a potentially valuable benefit for ultra-short investors: because they are floating rate, they adjust to changes in interest rates, helping to keep portfolio duration low and stable.

LOOKING AHEAD

There is a strong fundamental case for extending duration, and diversifying the asset mix, in search of yield. But the strategy is not without risks. That is one of the key reasons investors may want to go ultra-short in duration, instead of extending duration out past the three-year mark of “short-term” funds. Rates are expected to remain low, but for how long? Any hint of a rate increase can quickly roil bond markets and impact investors.

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On the one hand Fed chairman Bernanke said back in 2011 that rates would remain low for two years. But nearly two years later, there is little sign of a rate increase. In fact in February of 2013, and then again in March, Bernanke defended the low rates (and the Fed’s continued asset purchase program), implying that rates will remain where they are until the employment picture begins to improve.

The longer this economic strength persists, the more it argues for caution in moving out along the curve in search of yield. Ultra-short duration funds may be an investor’s best choice for “splitting the difference” and optimizing both sides of the equation: these funds invest in assets with higher yield potential, but do not lock the portfolio into a longer maturity and thus can ride up the yield curve with an increase in rates.

Not only do investors get an income benefit now, they may potentially gain from higher yields by rolling over assets if (and when) there is an uptick in rates. Further, a diversified mix of assets may help control volatility, which is an important consideration once an investor steps out of the relative security of money market funds. Ultra-short duration funds generally aim to find the right mix of assets  that will potentially have the least amount of impact on NAV volatility. Overall, ultra-short funds may be a valuable tool for yield-starved investors.  They offer higher yields than money market funds, less duration risk and lower volatility than short-term bond funds  and the liquidity that income-oriented investors demand.

William Belden is the Managing Director, Product Management for Guggenheim Investments.

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