BondsOnline Advisor

Short-Term Gains

by Stephen Taub

Are you one of those investors who are too spooked to stay in the bond market?

Who can blame you?

The US government bond market just suffered its worst largest quarterly loss in 24 years.

The Federal Reserve recently hiked short-term rates for the first time in several years and most pros expect it to raise rates a lot more over the next few years.

And none other than Pimco bond guru Bill Gross is making the media rounds talking down the prospects for fixed-income investments.

However, just because you are bearish on bonds, it doesn't mean you must empty your entire fixed-income portfolio and park it in money market funds and get less than 1%.

There are some relatively safe vehicles that throw off much more yield than those miserly money funds.

One place to look at is short-term bond funds.

The prices of these bonds do not react much to changes in interest rates. Meanwhile, the average fund in each of the short government, short-term bond, muni national short, and ultrashort bond categories outperformed the intermediate and long categories, according to Morningstar.

"The objective is to provide investors with excess returns relative to traditional money market strategies, while preserving capital and providing liquidity," says Paul Reisz, vice president and product manager, short-term strategy for Pimco, in an interview on his company's website.

"The main objectives of money market strategies are similar to those of the Short-Term Strategy--liquidity, principal preservation, and a reasonable return on investment," he adds. "However, money market investors are generally less focused on return and more interested in liquidity and principal preservation."

He explains that while money market strategies in general have durations of 90 days or less, PIMCO defines enhanced cash strategies, such as its Short-Term Bond Strategy, as having durations of one year or less.

"This duration means that it is possible for the net asset value of the Short-Term Strategy to fluctuate by not more than one percentage point for each percentage point change in interest rates," he explains. "So unlike money market investments, enhanced cash strategies can 'break the buck,' or move above and below $1 in price."

Morningstar recently singled out three short-term funds it especially likes--Goldman Sachs Ultra-Short Duration Government (GSARX), Metropolitan West Low Duration Bond (MWLDX), and T. Rowe Price Short-Term Bond (PRWBX).

Why did the fund rating firm decide on this trio? It screened funds in the four categories mentioned above-- short government, short-term bond, muni national short, and ultrashort bond. It then eliminated the funds with below-average yields and Morningstar Risk scores that rank in their group's worst 10%.

It also didn't include funds with expense ratios greater than 0.60%. "The range of returns in these categories is quite narrow, and low-cost vehicles typically win out," it stresses.

Morningstar also only included funds for which a Morningstar Analysis is available.

The Goldman fund actually enjoyed a positive return of 0.87% this year through July 13, virtually double the average fund in its category (0.44%). That's quite a feat. Its current yield is 3.74%.

"The fund sticks mainly to government bonds, so it doesn't take on much credit risk," Morningstar adds. The fund was also recently boosted by a large chunk of adjustable-rate mortgages.

The fund requires a minimum investment of $10,000 and its expense ratio is 0.46%.

The Metropolitan West fund has performed nearly as well as the Goldman fund. But, Morningstar says it sits at the other end of the credit-risk spectrum.

"Its managers have a proven ability to find mispriced corporate bonds and hold on to them as they recover from temporary problems," the fund rater explains. Be careful. The risk-taking tolerance caused the fund to lose a bit of money (down 0.4%) in 2002.

Its current yield is 4.36% and its expense ratio is 0.58%. Its minimum investment is $5,000.

The T. Rowe Price fund holds a large stake in corporate bonds, and typically holds a larger stake in mid-quality paper than most rivals, Morningstar points out in its report. On the other hand, the fund's duration is typically shorter than its peers, it adds.

"Over time it has been less volatile than the short-term average," says the report.

It is up 0.39% year-to-date compared to a mere 0.06% for its peer group. Its minimum investment is $2,500 and its expense ratio is 0.55%.
 

Stephen Taub is Contributing Editor to BondsOnline. Stephen has been covering financial markets for more than 20 years with Financial World magazine, Individual Investor.com, CFO.com, and others.