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Ultrashort Term Bond Funds

Ultrashort term bond funds (not to be confused with shorting) are mutual funds that include government bonds, corporate bonds, and mortgage-backed securities. As seen before, bonds offer fixed income with maturities varying from a few months to several years.

The ultrashort bonds have short maturity periods ranging from a few months to a year, thereby making them less sensitive to interest rate changes. So, are ultrashort bonds a solution to park cash needed in the short-term? Are the risks worth it? Lets find out.

Ultrashort Bond Funds vs. GICs and Money Market Funds

Apart from savings accounts, GICs and money market funds are used to park cash required in the short-term such as amounts meant for a down payment, vacation, car, etc. In terms of yield, ultrashort term bonds are supposed to provide better returns than GICs and money market funds. However, this increased return comes with higher risk.

Due to the need to provide a higher return than other typical short-term investment vehicles, these bonds invest in securities with average credit ratings. In addition, unlike GICs, the ultrashort bonds are not guaranteed by CDIC, leaving the principal prone to market risk; an increase in interest rates would entail a drop in bond prices.

Money market funds are also mutual funds (like ultrashort bond funds) but they are required by securities legislation to invest in low-risk instruments and their NAV does not vary too much.

Factors to Consider

  1. Credit Risk. It is possible that corporations or, sometimes, governments can default on their debt obligations. With ultrashort bonds investing in such debts, the credit risk can be lowered by choosing funds that invest mainly in federal and provincial/state debts. The yield may not be great but the chances of default or downgrades are minimized significantly. The higher the exposure to the corporate segment with lower credit ratings, the better the chance of falling prey to credit risk.
  2. Maturity Date. The shorter the term of bond maturity, the less the risk involved with regard to interest rate changes. Here’s an explanation about the relationship between interest rates and bond prices.
  3. Duration and Bond Price. It is known that bonds with a high duration have a greater price variation than those with a lower duration. The coupon rate, maturity date, and yield to maturity have a significant impact on the price volatility seen in bonds.

Is it for the Average Investor?

Ultrashort term bonds are a lot of risk for too small a gain. GICs and money market funds may be a better option for many investors looking for a short-term parking spot for their cash (not to mention a savings account at a bank). However, for investors who see otherwise, there are several options available to invest in them.

There is a list of top-performing ultrashort funds at MSN Money that could help your search. More funds of the same type can be found on this page but there may be some repetitions from the previous link. Canadian funds are limited; TD seems to be the only big player in this market and the performance of their ultrashort funds can be found on Page 7 of this PDF link.

Have you invested in ultrashort bonds (mutual funds or ETFs)? If so, how did your fund/ETF fare? Do you think they are worth the risk?

About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism.  You can read his other articles here.

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About the author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.

{ 4 comments… add one }
  • Ken Faulkenberry December 21, 2011, 11:18 am

    In their quest for yield investors are taking on risks that are not compensated with equal rewards. Sometimes its better to preserve capital and wait for better opportunities.

  • Saveddijon December 21, 2011, 9:20 pm

    So what exactly is ultrashort?

    I’m invested in XSB and XCB. XSB at least is short. Are these considered ultrashort?

    (I also have a significant chunk in cash, and the bulk of my equities are dividend payers.)

  • Clark December 22, 2011, 7:30 pm

    @Saveddijon: XSB has over 90% of its bonds maturing in 1 – 5 years; ultrashort bonds are those maturing in months rather than in years.

  • CommanderT December 23, 2011, 3:16 am

    While it is true that the underlying investments are not the same credit quality as GICs and other money market funds, I would not think that the risk of default is significant on these funds. This is purely due to the fact that the maturity is so short. Most of the time a company will have its debt downgraded to junk status well before the company actually goes broke. As long as this company is only purchasing funds that are investment grade to begin with I would be shocked if it had defaults on any regular basis.

    However, I have not looked at the yields on thes bonds. If they are not appreciably higher then money market funds than there is no advantage to this fund.

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