With interest rates at their lowest levels in 41 years and no signs of them rising, fund companies have been scrambling to offer nervous investors alternatives to money market funds.
The solution? Short or ultra-short bond funds, which can provide a significantly higher return without significantly greater risk.
Since the end of November, three new short duration bond funds have hit the market, and a handful debuted earlier this year, including new funds within the Bank of New York's Hamilton Funds group and the Eclipse Funds, managed by New York Life Investment Management, both of New York.
The Enterprise Group of Funds of Atlanta late last month introduced its Enterprise Short Duration Bond Fund, managed by MONY Capital Management of New York, a sister company to Enterprise.
The Armada Funds, managed by National City Investment Management Co. of Cleveland, on Dec. 2 debuted its Armada Short Duration Bond Fund, designed for both retail and institutional savers who want a little higher yield out of their investments, said Kathleen Barr, SVP and managing director at National City.
And on Dec. 4th, socially conscious Citizens Funds of Portsmouth, N.H., launched the Citizens Ultra Short Bond Fund, which expects to offer a higher yield and return potential than a money market fund, but with limited risk.
In early October, Federated Investors of Pittsburgh introduced a retail A-share class for its formerly institutional-only Federated Ultrashort Bond Fund that originally launched in 1997. According to a spokesperson, Federated decided to make the fund available to retail investors because it was seeing very strong fund sales. The fund's assets now top $1.8 billion.
"Many saver clients are looking frantically for options to money market funds," said Gregory Staples, lead manager of the Enterprise Short Duration Bond Fund. Others are simply looking for a place to park money in light of the unpredictable equity markets, he added.
One other alternative has been stable-value funds. Jill Cuniff, managing director and chief investment officer of Gartmore Morley Financial of Lake Oswego, Ore., has seen assets in her boutique firm, which specializes in stable value, swell from $70 million at the end of June to $180 million. Cuniff claims that stable-value funds are more attractive to investors than bonds in a rising rate environment.
Regardless, both short-duration bonds and stable-value funds can offer juicier yields than struggling money market funds. As of Dec. 5, the average short or ultra-short duration bond fund was yielding 2.2%, according to Lipper of New York - more than double the paltry 0.94% return of the average taxable money market fund, according to iMoneyNet of Westborough, Mass. The Gartmore Morley Capital Accumulation Fund, meanwhile, is up 4.3% year to date.
Short duration bond funds can offer higher returns than money funds because they invest in longer-term bonds that carry higher rates. By law, money funds can only invest in the shortest-term fixed-income securities with a maximum maturity of 13 months. And a fund's entire portfolio cannot exceed a 90-day average maturity, said Scot Johnson, co-manager of the AIM Short Term Bond Fund, which debuted in August.
On the other hand, short bond funds are generally limited to bonds with maturities of three years or less. That difference can translate into a 2.5% or even greater return, Johnson said.
"Even if you only pick up an extra 50 basis points, you're getting 50% more income," said Andy Harding, director of taxable fixed-income investment at National City.
Like all good things in life, there's a trade off. The longer the bond maturity, the higher the interest rate risk, said Andrew Clark, senior research analyst in Lipper's Denver office. In fact "duration" actually refers to the amount of sensitivity a bond has to changes in interest rates, either up or down. Consequently, short-duration bond funds whose bonds have short maturities are less sensitive to interest rate changes than intermediate- or long-term bond funds, which hold bonds with much longer maturities.
That sensitivity to interest rates is precisely why mutual fund companies have chosen to jump on the short-duration bond fund bandwagon. Most fund insiders agree that with interest rates hovering at record low levels, the only direction for rates to go is up.
At some point, rates will go up, said Dave Rieben, director of internal sales at Calvert of Bethesda, Md., which debuted its short duration income fund at the beginning of the year. But when that happens, investors who have flocked to bond funds will find they are risking principal since bond prices move inversely to interest rates, he explained.
Investors "can mitigate that risk by investing at the short side of the duration curve," he said.
And if interest rates don't begin their ascent for the next six to nine months, investors will be garnering a higher yield over money funds rates, Harding said.
Credit risk is another issue. Some funds are leaning more heavily into Treasury securities or money market investments, while others are investing greater proportions into corporate bonds. Still others have chosen to assemble a diversified basket of bonds acquired from various bond markets. And while most have decided to stick to investment-grade securities, some are dabbling in lower-quality bonds or the high-yield market to punch up performance.
The biggest holding of the Gartmore Morley Capital Accumulation stable-value fund, for its part, is mortgage-backed securities, Cuniff said. Another distinguishing feature of these types of investments is that they have a type of insurance wrap, to protect against volatility.
Indeed, no short-duration bond or even stable-value fund is created equal.
While short or ultra-short duration bond funds are striving to outperform money funds, they aren't exactly generic substitutes. The goal of money funds is to provide a return and keep the fund's net asset value at a constant $1 per share. But the share prices on short duration bond funds can and do fluctuate both up and down.
"People are gravitating to these funds, and marketers are pushing them freely, at the wrong time," said Don Cassidy, senior analyst at Lipper. "Whether these funds are being sold under the description stable value' or otherwise, they do not provide the principal protection that a money fund does."