A Federal Reserve policy shift that has created uncertainty over interest rates, is generating renewed interest in ultrashort-term bond funds.
Slowing economic growth and quiescent inflation—the same factors that led the central bank to pause its interest-rate increases earlier this year—have left short-term and long-term interest rates at about the same level. That’s good for ultrashort bond funds, which typically invest in high-grade paper with duration of less than a year.
Ultrashort funds have yields that aren’t far from longer-term funds, and their short durations make them less vulnerable to rising market interest rates. Duration is a measure of the sensitivity of a bond’s price to a change in interest rates. When rates rise, bonds with longer durations fall more in price than those with shorter durations.
As of Feb. 28, ultrashort mutual funds and exchange-traded funds yielded 2.67% on average, versus 2.99% for intermediate-term funds, which typically have durations of 3.5 to six years, according to fund researcher Morningstar Inc.
Larry Wasserman, head of due diligence and investment opinion at PNC Investments, figures the central bank will be on pause for most of the year as it evaluates inflation, jobs and global growth. PNC expects the Fed to boost rates once this year, in September, if inflation picks up.
In that environment, with the Fed “watching and waiting” for now, “you aren’t getting a lot of pickup for going further out on the yield curve,” he says.
‘The place to be’
The yield curve plots the yields of bonds with different maturities. As short-term interest rates are so close to long-term rates, the yield curve has been flat and recently inverted, with the three-month Treasury bill yield surpassing the 10-year Treasury note yield.
“Shorter duration, higher-quality bond funds are the place to be, with government and investment-grade corporate paper,” Mr. Wasserman says.
The volatility that has kicked up in the market amid the uncertainty over Fed policy also is making ultrashort funds more alluring now, as they generally are less volatile than longer-term funds, says Mary Ellen Stanek, chief investment officer at Baird Advisors. “Why take risks in this part of your portfolio,” she says, when investors generally hold bonds for safety and stability.
A net total of $1.46 billion flowed into ultrashort bond mutual funds and exchange-traded funds in the year ended Feb. 28, according to Morningstar.
Two ultrashort-term bond funds that are highly rated by Morningstar are Fidelity Conservative Income Bond Fund (FCONX) and DFA One-Year Fixed Income Portfolio (DFIHX), both of which have low fees, according to analysts. The Fidelity fund’s annual expense ratio is 0.35%, while the DFA fund’s ratio is 0.17%.
In addition to the low fees, the Fidelity fund offers a management team with deep resources that “adds value with selective risk-taking in very short-term corporate debt,” Morningstar analyst Alaina Bompiedi writes in a report. The managers practice “vigilant risk management,” she says, adding that “this fund is more conservative than many in the ultrashort bond Morningstar category.”
Through March, the Fidelity fund had annualized returns of 2.36% for one year, 1.58% for three years and 1.08% for five years, according to Morningstar. Its trailing 12-month yield is 2.33%.
The DFA fund benefits from a “conservative credit profile” in addition to its low fees, Morningstar analyst Adam McCullough writes in a report. As a result, the fund “should provide attractive risk-adjusted performance over the long run,” he says. It shifts along the yield curve for the highest risk-adjusted return opportunities.
Through March, the DFA fund had annualized returns of 2.53% for one year, 1.33% for three years and 0.97% for five years, according to Morningstar. Its trailing 12-month yield is 2.01%.
Stick with a strategy
When the Fed makes significant changes, such as its shift to a neutral policy this year, it makes sense for investors to adjust their portfolios accordingly, experts say. “There is a need to be more agile and responsive, especially given the extent to which initial [bond] valuations have been distorted by years of unconventional monetary policy,” says Mohamed El-Erian, chief economic adviser at Allianz.
But experts generally recommend against shifting a portfolio in anticipation of, or in reaction to, less significant changes in Fed policy. Investors should determine their investment goals, risk tolerance and time horizon and stick with their strategy, Ms. Stanek says. “Don’t try to outsmart the market.”
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