(12/12/11) 2 Rock-Solid Short-Term Bond Funds

Fallout from the recent financial crisis reached all corners of the mutual-fund landscape, but the dismal performance of many short-term and ultra-short bond funds was particularly disconcerting, notes Kathryn Young of Morningstar FundInvestor.

Many investors assume short-term bond funds are low-risk and use them as cash substitutes. But some funds lost double-digit sums in 2008, thanks in large part to outsized stakes in subprime mortgage-backed securities.

The two hardest-hit funds, Schwab YieldPlus and SSGA Yield Plus, have been liquidated. However, some of the other worst performers, many of which came from well-respected bond managers like Metropolitan West and Fidelity, remain among investors’ options.

Most funds have scrubbed the worst mortgage-related securities from their portfolios, but as yields available on short-term government-backed securities have hovered near historic lows, they’ve had plenty of incentive to stretch for yield in other ways. One area they’ve pursued is lower-quality corporate bonds.

Corporate fundamentals have improved dramatically since the crisis, and many companies are sitting on mounds of cash, which reduces the probability of widespread defaults in coming years. Plus, those bonds have a much longer history for stress tests than exotic mortgages did. Those factors make it easier for managers to justify such exposure in these funds.

Still, the credit risk inherent with those bonds could threaten the stability investors expect from these funds, and a euro crisis-inspired credit sell-off in August and September provided an opportunity to gauge just how vulnerable the funds have become.

All credit-sensitive sectors came under pressure, but high-yield corporates led the way down: The Merrill Lynch US High Yield Master II Index lost more than 7% in that two-month stretch. The Barclays Capital US Credit Index, which comprises investment-grade securities, managed a 0.6% gain despite losses experienced by some subsectors, especially financials.

In general, the results for shorter-term bond funds are encouraging. The average short-term bond fund lost a modest 0.5% over the two-month stretch, and the average ultra-short fund lost 0.3%.

The losses weren’t enough to wipe out gains notched earlier in the year, either. The average short-term bond fund ended September with a 1.2% gain for the year, while the average ultra-short fund ended up 0.3%.

Some funds that were burned the most in 2008 have reformed. Fidelity's Ultra-Short Bond's (FUSFX) loss, for example, wasn’t much worse than average.

Still, there are some funds that may not live up to investors’ expectations for capital preservation. DWS Ultra Short Duration (SDUAX), which holds 8% in junk-rated debt, lost more than 3% between August and September. Metropolitan West Ultra Short Bond (MWUSX) and Metropolitan West Low Duration Bond (MWLDX) posted losses well above their respective category averages.

More than ten funds lost 2% or more, which is significant for funds that typically expect to gain in the neighborhood of 2% to 4% annually.

With yields on government-backed bonds so low, investors can use a fund’s yield to help gauge how much credit risk it may be taking on. If your fund’s yield is significantly higher than the category average, watch out.

The typical short-term bond fund has a 12-month yield of about 2.2% right now, while its ultrashort siblings yield 1.2% on average. Those funds that fared the worst generally have higher potential payouts. DWS Ultra Short Duration, for example, yields 3.6%.

A sensible yield and a lack of credit risk certainly don’t make for a riskless fund. Funds with a higher-quality bent may be more sensitive to rising interest rates, for example.

Fortunately, there are options that typically balance exposures and risks well. Among our favorites are T. Rowe Price Short-Term Bond (PRWBX) and Vanguard Short-Term Investment (VFSTX).