Not as Good as Cash

When the likes of Fidelity, Legg Mason, Pimco and Schwab bungle the same kind of income investment, I can't help but wonder if there's something wrong with the concept. I'm talking about cash alternatives known as ultra-short-term bond funds. By keeping their duration (a measure of interest-rate sensitivity) to one year or less, these funds, in Morningstar's words, are supposed to be only "one step beyond a money-market fund" in terms of risk. But the average ultra-short-term fund lost 8% last year. That's not my idea of a low-risk investment. From the middle of 2007 through the end of 2008, many of these funds lost more than 20%. No money-market fund, not even the impaired Reserve Fund, ever came within a step of a 20% loss.

Ugly numbers. As government efforts to relieve the credit crunch have taken hold, the group has stabilized and, in fact, outpaced most other bond-fund categories in the early stages of 2009. Year-to-date through March 6, the average ultra-short-term fund was flat. The average was pulled down by continuing problems at such disasters of 2008 as Pimco Floating Income (symbol PFIAX), down 25% last year and 1.8% this year; Metropolitan West Ultra Short Bond (MWUSX), down 21% in '08 and 3.2% in '09; and Schwab Yield Plus (SWYPX), down 35% last year and 13.7% so far this year.

Although these funds can invest in Treasury securities, mostly they buy slices of collateralized mortgage obligations and other packages of business and consumer loans with relatively short durations. This strategy theoretically keeps the volatility in the funds' net asset value per share to a minimum, while producing a yield closer to that of a fund that owns bonds with longer maturities.

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The problem is that the market for mortgage securities grew to be so huge that many ultra-short funds filled their portfolios with mortgage paper. I don't need to tell you what's happened to the mortgage market, and that explains why so many of these funds blew up.

Some ultra-short funds also trade such things as Eurodollar futures and other derivatives to pump up their yields. So today, for example, Metropolitan West Ultra Short pays 7.2%, Pimco Floating Income yields 6.2%, and Legg Mason Partners yields 4.4%.

I asked some advisers if this might be a good time to buy. Their verdict: not yet. By the time ultra-short funds can unload the rest of their garbage, global economies will be on the mend and interest rates will probably be climbing. That will eat into the returns of most bond funds (bond prices move inversely with interest rates). At that point, certificates of deposit and money-market funds will look much more appealing.

To be fair, a few ultra-short funds have performed as advertised, delivering modest returns with minimal volatility. These funds stick almost entirely to government-guaranteed bonds, such as Treasuries and Ginnie Mae securities. Managers Short Duration Government (MGSDX) holds mostly mortgages, but only those guaranteed by Uncle Sam. It yields 3.8%. The conservative DFA One-Year Fixed-Income (DFIHX), which yields 2.8%, is a good choice if you work with an adviser who uses DFA funds. Little-known Allegiant Ultra Short Bond A (ASDAX) has been a terrific performer, finishing number one in the category last year, with a return of 4.4%, and in the top 10% in 2007, with a gain of 5.4%. Over the past five years, the fund's NAV per share has traversed a narrow range, from $9.81 to $10.08. The fund, which yields 3.5%, is also heavy on Treasury securities and U.S.-backed mortgages. Derivatives are banned.

Andy Harding, one of the fund's co-managers, is confident he can deliver a decent yield for the rest of 2009 while living up to the standard that "capital preservation is everything." If Allegiant's bigger and better-known competitors had followed that model, the fund industry would now have one less embarrassment to contend with.