What it means
Bonds are loans that investors make to governments and companies in return for interest. The longer a bond has until repayment, the more its price tends to move when interest rates change, so a fund holding bonds that mature very soon sees much smaller movements.
Ultra-short funds usually hold bonds, commercial paper and other short-term debt, with an average duration of less than one year. Duration is a measure of how sensitive a bond's price is to changes in interest rates, and a duration of 0.5 means a 1% rise in rates would cut the price by roughly 0.5%.
These funds are used by investors and businesses that want a slightly higher return on spare cash than a bank deposit pays, without locking it up for years. Corporate treasurers, for example, may use them for money they will not need for several months.
They sit between money market funds and short-term bond funds in risk and return. A money market fund aims to hold a stable value of $1 per share, whereas an ultra-short bond fund has a changing price and can lose money, especially if some of its holdings lose credit quality.
The fund may also hold lower-rated bonds or other assets to boost income, so investors should check credit quality, average maturity and fees. A very high yield compared with similar funds is often a sign of extra risk.
In a period when rates are rising, the fund can reinvest maturing bonds at higher yields quickly, which is an advantage. When rates are falling, income can drop fast, and the fund will not lock in higher rates for long.
In practice
Real-world examples.
Example
A software company has $2,000,000 of cash set aside for a tax payment due in nine months. The treasurer places it in an ultra-short bond fund to earn more than the bank pays. She accepts that the fund's value may move slightly and keeps a smaller sum in a deposit account for certain needs.
Example
A retired couple wants a place for $100,000 they might need for a home repair within two years. They choose an ultra-short bond fund for modest income with low volatility. They check the fund's holdings and see that most are rated investment grade.
Example
A university treasury compares an ultra-short fund yielding 4.6% with a money market fund yielding 4.2%. The extra 0.4% would add $8,000 a year on $2,000,000. The treasury weighs this against the small chance of a price decline and decides to hold half in each.
Formula
Calculation
Approximate price change = - duration x change in yield
An ultra-short bond fund has a duration of 0.5 years. Suppose market interest rates rise by 1.00 percentage point (from 4.00% to 5.00%) and an investor holds $200,000 in the fund.
Approximate price change = -0.5 x 1.00% = -0.5%.
Dollar change in value = 200,000 x -0.005 = -$1,000.
In the same period, the fund earns interest at a yield of 4.50% a year. Over twelve months, income would be 200,000 x 0.045 = $9,000, so the net gain is 9,000 - 1,000 = $8,000, and the interest earned outweighs the price dip. A fund with a duration of 5 would have lost ten times as much on the same rate rise.Case study
Seen in the real world.
Brightwater Logistics is a fictional company, and this story is illustrative. Its finance director had $5,000,000 in a bank account earning very little and moved $3,000,000 into an ultra-short bond fund yielding 4.4% a year.
Over the next year, the fund produced $132,000 of income, which is 3,000,000 x 0.044. Rates rose during the period, and the fund's value dipped by 0.3%, or $9,000, before recovering as bonds matured and were replaced with higher-yielding ones.
The finance director had told the board to expect small fluctuations, so the dip caused no alarm. The net gain was about $123,000 on the $3,000,000, well above what the bank account would have paid, and the experience showed that this type of fund suits money with a flexible time horizon.
Watch out
Common mistakes.
- Treating an ultra-short bond fund as a bank deposit. Its value is not guaranteed and can fall.
- Assuming it is the same as a money market fund. Money market funds follow stricter rules and aim for a stable price.
- Chasing the highest yield. A much higher yield than similar funds often means lower-quality holdings.
Questions
People also ask.
How short is ultra-short?
Most funds have an average duration of under a year, often a few months, though definitions vary.
Can I lose money?
Yes. Prices can fall if interest rates rise or if a borrower's credit quality deteriorates, although the moves are usually small.
Who typically invests?
Savers, corporate treasurers and institutions with cash they may need within a year or two.
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