Don't Save a Seat at the Ultrashort Revival

• By Miriam Sjoblom
• On 7:00 am EDT, Wednesday October 21, 2009

The Dow may have crossed five figures in October, but bond funds have been mutual fund investors' darlings so far this year. Of the net $273 billion that flowed into mutual funds from Jan. 1 through Sept. 30, nearly $200 billion went to taxable-bond funds, and another $57 billion to municipal-bond funds, according to Morningstar's estimates. Digging deeper, the trend reflects investors' apprehension after a harrowing 2009. Close to three fourths of the amount flowing into bond funds this year has gone into taxable and tax-exempt funds that focus mainly on investment-grade bonds of intermediate- or short-term maturities. And although they don't represent a big piece of the total pie, interest in ultrashort-bond funds has also been percolating.

That's a little surprising given the colossal blowups that plagued the category during the credit crisis. Originally billed as one step up from money markets in both risk and reward, these funds, some of which had delved into subprime-backed and other nonagency mortgages, were among the first to feel the sting of the credit crisis. As outflows and losses went hand-in-hand, some of the hardest hit were also the category's largest. The ignominious Schwab YieldPlus (NASDAQ:SWYSX - News), now at roughly $210 million in assets, once bulged at $13 billion. While most shareholders have gotten out, the poor souls who stuck with this fund have lost a cumulative 44% of their investment since mid-2007. At its June 2007 peak, the ultrashort-bond category had $37 billion in assets, but it lost half that amount to outflows by the end of 2008.

As the ultrashort fiasco wore on, it provided object lessons galore, from the danger of relying on backward-looking risk measures, such as standard deviation and past losses, to the threat posed by outflows in illiquid markets. And even though the pain has subsided, companies responsible for the most damaged funds in the group remain mired in lawsuits and regulatory investigations. Just last week, Schwab announced that it had received a Wells notice from the SEC, alerting the company to potential civil enforcement action because of possible securities law violations. One of the more serious charges was leveled against Evergreen Funds, a unit of Wachovia that was acquired by Wells Fargo (NYSE:WFC - News) in December 2008, for mispricing securities in the now-defunct Evergreen Ultra Short Opportunities. The fund forked over a $41 million settlement to regulators.

But more investors have been coming than going so far in 2009 (to the tune of $9 billion). Why the change of heart? For starters, as the Fed has kept its target rate near zero and other short-term rates have followed suit, you're lucky to get a yield of mere fractions of a percent in a money market fund. By comparison, the monthly SEC yield on ultrashort-bond funds is in the 1% to 3% range. At least the bulk of new assets have gone to resilient funds from PIMCO, Federated, Franklin, and Goldman Sachs, while money continues to trickle out of the category's worst performers. Freshly burned, firms like Fidelity have gotten religion and are reining in risk to help ensure that they're able to meet shareholder expectations going forward. Ironically, the fact that Fidelity Ultra-Short Bond (NASDAQ:FUSFX - News) is lagging the majority of the group, with a thin 0.8% gain during 2009's rebound for risky assets, is probably as sure an indicator as any that the fund is much more conservatively positioned today than it was in the early stages of the credit crisis.

But even though there were a few respectable ultrashort funds in 2008, we still question their overall usefulness. Even funds with good long-term records and pedigrees let their shareholders down when it mattered most: Close to two thirds of the category actually lost money in 2008, and a third suffered double-digit drops. While the lessons of the past two years will likely stick with managers for many more to come, it's after a prolonged period of smooth sailing, when compressed yields tempt sanguine managers to take on more risk for relatively meager rewards, that these funds could once again get into trouble. Fund investors themselves are hardly immune from the dangers of complacency and yield-chasing. Poor or delayed disclosure is one more reason that ultrashort-bond fund investing requires an extra layer of vigilance.

For most near-term goals, we think short-term bond funds can often do the trick just as well. The category had its share of dogs in 2008, but it wasn't smacked by the same treacherous combination of price declines and outflows. As a result, many of the funds that gave up ground last year were able to hold on to battered securities and eventually benefit from this year's recovery. In fact, all but a handful of funds in the category are comfortably in the black since Lehman Brothers' collapse kicked off the worst of the financial crisis in September 2008. One of our favorites in the group, Vanguard Short-Term Bond Index (NASDAQ:VBISX - News), ranks among the lower-yielding funds in the bunch because of its hefty stake in short-term Treasuries. But it has only lost money in one 12-month period in its 15-year history, and then just a fraction of a percent. Those who want to get a little more bang for their buck have a fine option in the actively run T. Rowe Price Short-Term Bond (NASDAQ:PRWBX - News). Longtime manager Ted Wiese has also excelled at preserving capital year after year. After the severity of last year's financial crisis, few of these fund's rivals can say the same.

Miriam Sjoblom does not own shares in any of the securities mentioned above.

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