Ultra Short-Term Bond Investors Fighting Two Battles

Diversity is key amid yield drought and Fed-induced volatility.

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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.

[See 50 Best Funds for the Everyday Investor.]

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.

[See 5 Reasons the Government Should Be Run Like a Business.]

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.

[See 3 High-Yielding, Fixed-Income Investments.]

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.