Some investors see a role for funds that hold very short bonds, despite the surprisingly big losses that some of these portfolios posted in 2008

Journal Report

Now that the crisis has eased and a period of rising rates is widely expected, ultrashorts again are being marketed with attractive yields for money that investors need to park for relatively short periods.

But many financial advisers see these funds as offering too little reward for the amounts of risk they still carry—especially in the event that rates increase.

Ultrashort-bond funds trade in debt that generally matures in less than 12 months. The fund companies market them as paying more interest than bank CDs, savings accounts or money-market funds—and carrying less risk than short-term bond funds, which focus on debt maturing in one to three years. Accordingly, many people view ultrashort-bond funds like cash, only better because of their rates.

Vise Grip

But looks can be deceiving. The worst losers among ultrashort funds in the 2008 crisis were those that tried to boost yield with longer-term issues or nongovernment-agency-mortgage bonds—bets that went bad when demand for mortgage bonds and other marginal credits evaporated.

ENLARGE

Ellen Weinstein

The biggest ultrashort-bond fund at the time, Schwab YieldPlus. fell 35% in 2008. Shareholders of offerings from Metropolitan West Asset Management, State Street Corp. and Fidelity Investments, among others, suffered lesser but still-stinging losses. Only a handful of taxable ultrashort funds emerged relatively unscathed, such as Pimco Short-Term. which fell 1.6%.

Ultrashort funds have been paying for their mistakes ever since. Charles Schwab Corp. paid $119 million in January to settle Securities and Exchange Commission allegations that it misled investors about the risk of YieldPlus. The fund had $13.5 billion in assets and more than 200,000 accounts at its 2007 peak; recently it commanded just $150 million. A Schwab spokesman said the firm had no comment about YieldPlus.

Moreover, many financial advisers no longer see a compelling need for a product that is sandwiched, not always so neatly, between money markets and short-term bonds. Ultrashort funds that invest in taxable bonds yielded 1.26% at the end of January, according to the New York fund-research firm Strategic Insight. But with some online-bank savings accounts paying 1.1%—with federal insurance—some investment strategists say ultrashort funds don’t offer enough reward to justify putting money at greater risk.

This isn’t your cash alternative, says Miriam Sjoblom, an analyst at Morningstar Inc. You’re not getting much yield for taking on the risk. What you absolutely need in the next several months, keep in cash.

Not So Simple

It turns out that ultrashort funds aren’t so simple after all. As with all bond funds, investors have to contend with both interest-rate risk and credit risk.

Schwab YieldPlus and other funds got crushed when downgrades and defaults devalued many of their holdings and managers had to dump assets to meet redemptions. Typically, the most liquid bonds went first, leaving the funds thick with flotsam that lowered values further.

The fund managers seem to have learned a lesson: Don’t try to load up on one type of risk, says Randall Bauer, manager of $1.5 billion Federated Ultrashort Bond. which lost 4.4% in 2008.

Mark Balasa, a financial adviser with Itasca, Ill.-based Balasa Dinverno & Foltz LLC, says, there’s less risky behavior than before, but you still have to pay attention.

Then there is the interest-rate risk. Ultrashort portfolios are required to have an effective duration, a measure of a fund’s sensitivity to interest-rate changes, of one year or less. Some try to boost yield by mixing in lower-quality bonds and issues that repay principal in 10, 20, even 30 years. The managers then use derivatives and hedging tactics to bring the portfolio’s effective duration into line.

But the risk remains: Longer-term bonds carry a greater chance of loss from credit defaults and interest-rate swings. Bond values fall when interest rates climb, and vice versa. So, in a rising-rate environment, ultrashort funds in theory should be able to reinvest maturing debt at higher yields and thus protect shareholders’ principal better than funds that own longer-term bonds exclusively.

However, the slight yield advantage ultrashorts have over money markets and CDs could be lost as rising rates sap the value of the portfolio’s holdings, especially long-dated bonds, says Greg McBride, senior financial analyst at Bankrate.com. By contrast, an online-bank savings account carries no interest-rate risk and its yield moves in tandem with rates.

Plus, ultrashort funds aren’t cheap. The average fund in the category collects 0.69% of the value of your investment each year, according to Morningstar. That’s a high break-even point for such a low-returning asset. (Quoted yields and returns are net of those expenses.)

Possible Roles

That said, ultrashort funds are generally more diversified and own stronger credits than was true in 2008. So if you choose carefully, they can serve a couple of specific purposes.

Mr. Balasa says he has used ultrashort funds for clients who are looking at a tax bill several months out and need a liquid, low-risk placeholder.

If you see a role for ultrashorts in your portfolio, look first at government ultrashort funds, which buy Treasurys and other federally backed securities and are largely free from state and local taxes. These funds carry virtually no credit risk and currently provide more income than their counterparts, recently yielding about 1.66% on average, partly because many hold some securities backed by adjustable-rate mortgages.

Or consider the exchange-traded Pimco Enhanced Short Maturity Strategy ETF. This taxable offering is cheaper than many actively run ultrashort funds. Its expenses are 0.35%, and like all ETFs, its portfolio holdings are updated daily.

Pacific Investment Management Co. now commands a big chunk of the ultrashort-bond-fund market. Pimco Short-Term has $11.5 billion in assets, while the Short Maturity ETF’s assets total just over $900 million, according to Morningstar. The entire ultrashort-fund category had about $36 billion at the end of 2010, compared with $200 billion for short-term bond funds, according to Strategic Insight.

Above all, do your homework. Ask the fund company about the manager’s strategy and use of leverage. Look at holdings in terms of liquidity, structure and credit risk. Watch out for heavy concentration in an asset class, or an unusual amount of longer-dated securities—and pay attention to the fund’s record in 2008.

Mr. Burton is the Money & Investing editor at MarketWatch in San Francisco. He can be reached at jburton@marketwatch.com .