Ultrashort bond funds are an appealing investment vehicle for their high returns and purported safety. They fared well prior to the financial crisis that arose in 2007, but during the 2008 recession some funds experienced tremendous losses. A few funds recovered the following year with the government's help, but many hemorrhaged and closed. Whether or not you decide to invest in this type of fund, make sure you are among those who've seen the investment pay off by closely evaluating its risk.

SEE: The 2007-08 Financial Crisis In Review

What They Are
An ultrashort bond fund is a mutual fund. They consists of various investments that include government, mortgage-backed and corporate bonds. These fixed-income securities generally have short maturities ranging from three months to a year, making the funds less sensitive to interest rate changes. Some, however, have lasted as long as two years. These funds were designed to have higher yields than other investments, such as money market funds and certificates of deposit (CDs), but they also have more risk.


Safety Is Not Guaranteed
These funds have invested in securities with less than stellar credit ratings in order to get better results. Prices for these funds can be a dollar per share, but that amount can turn sour when changes occur in the market that risk principal, especially during continued periods of rising interest rates. Also, the investment vehicle hasn't been guaranteed or insured by government agencies, such as the FDIC.

SEE: The History Of The FDIC

The ultrashort bond fund gained more interest from investors in the late 1990s. Many firms sold them as a "cash alternative." Some even allowed check-writing privileges. They were inappropriately considered safer than money-market funds by some, and were called "the safest of all bond funds." However, some of these funds lost their appeal and were considered unstable as the mortgage and credit crisis ensued.

During the second half of 2007, popular funds, such as Fidelity Ultra-Short Bond Fund and Schwab Yield Plus, saw their values sink and redemptions increase. Many funds had more than half of their assets in mortgage-backed securities. "Some portfolio managers increased their mortgage-backed securities holdings without adequately analyzing and disclosing the additional risk that the higher yields on mortgage backed securities implied," Securities Litigation and Consulting Group explained in a study.

Weigh the Risk With the Rewards
Now that you are aware of the fund's history, the Securities Exchange Commission (SEC) suggests thinking about the risk and rewards when getting involved.

For instance, credit downgrades and defaults can occur, but credit risk can be lessened if the fund's main investment is in government securities, such as Treasury bonds. These securities are backed by the U.S. government and don't have to deal with local and state taxes. Analysts indicate that these types of funds have shown modest returns with less volatility during the recession.

Maturity dates that are longer than usual can make the investment vehicle riskier than those with a shorter than average maturity date. The longer period exposes the fund to fluctuation in interest rates. Keep in mind this inverse relationship: when interest rates rise, the value of the debt securities falls.

Alternatives
CDs offer the low-risk investment that you may be looking for and they easily convert to cash. CDs are insured by the FDIC for up to $250,000 (coverage as of 2012) and offer fixed terms. A set amount of money is typically invested within a span of three months to five years and the interest rates are usually fixed at higher rates than what you would receive from a savings account. When it reaches maturity you can redeem it and get the cash plus the interest accrued. CDs are purchased either at your bank or a brokerage firm.

SEE: How To Create A Laddered CD Portfolio

Money-market funds have been the ultrashort bond funds rival. While they both are mutual funds and aren't insured by the FDIC, they have a few differences. Unlike an ultra-short bond fund money-market funds' net asset value (NAV) doesn't fluctuate, they try to maintain a constant of a dollar per share. Money market funds are also required by law to invest in low-risk securities.

Do Your Research
It's always important to investigate where you are putting your money. For instance, with an ultrashort bond fund you'll want to find out the top performers. Examine performance charts. Learn how the fund was configured. Identify the securities that make up the portfolio. Determine the duration of the fund to consider how sensitive it may be to interest rate changes. You can do this by sifting through documents, such as the prospectus, profile and shareholder's report to help understand the companies strategy and risks. While you're looking through the documents, find out how long the fund has operated, the frequency at which it buys and sells securities, and any operational changes.

SEE: Evaluating Bond Funds: Keeping It Simple

The Bottom Line
Ultrashort bond funds may have been designed to give you "more bang for your buck" with less risk and higher yields, but they have had an unstable history. While government, financial advisors and analysts provide more oversight, take steps to make sure you see benefits of the fund. Start by doing a thorough research of the fund's present and past activities. Past performance won't tell you all you need to know about its future, but it can provide valuable insight about its volatility and how it's been handled. Also, weigh the rewards with the risk and keep in mind that safety isn't always guaranteed.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 First Pacific Advisors Funds for Retirement Diversification in 2016

    Learn about three mutual funds from First Pacific Advisors for including in a well-diversified retirement portfolio. Discover which fund truly stands out.
  2. Stock Analysis

    Analyzing Microsoft's Return on Equity (ROE) (MSFT)

    Discover a detailed analysis of Microsoft's historical return on equity, and learn how its ROE stacks up to its competitors in the tech industry.
  3. Investing Basics

    Defining The 3 Types Of Investments

    Investments can be divided into three distinct groups – ownership, lending and cash equivalents.
  4. Mutual Funds & ETFs

    Top 3 UBS Global Funds for Retirement Diversification in 2016

    Learn about UBS's asset management business, past mutual fund performance and the top three UBS mutual funds to consider for retirement diversification.
  5. Fundamental Analysis

    3 Misconceptions About Warren Buffett

    Learn why Warren Buffett is the man behind the curtain and how he is misunderstood regarding the ways he has adapted and changed his investing approach over the years.
  6. Mutual Funds & ETFs

    Invesco’s Top Funds for Retirement

    Here's a list of Invesco investments—retirement funds—that may work for you if you have the time to let them mature over the long term.
  7. Mutual Funds & ETFs

    Top 4 Royce Funds for Retirement Diversification in 2016

    Discover four of The Royce Funds mutual funds suitable for diversifying retirement portfolios that focus on investing in small-cap companies.
  8. Mutual Funds & ETFs

    Top 3 VALIC Funds for Retirement Diversification in 2016

    Learn about the VALIC fund family, its performance relative to its peers and the top three VALIC funds to consider for retirement diversification in 2016.
  9. Investing Basics

    Contingent Convertible Bonds: Bumpy Ride Ahead

    European banks' CoCos are in crisis. What investors who hold these high-reward but high-risk bonds should know.
  10. Mutual Funds & ETFs

    The 4 Best T. Rowe Price Funds for Growth Investors in 2016 (TROW)

    Discover the four best mutual funds administered and managed by T. Rowe Price that specialize in investing in stocks of growth companies.
RELATED FAQS
  1. How liquid are BlackRock mutual funds? (BLK)

    BlackRock, Inc. (NYSE: BLK) mutual funds are very liquid, as are all mutual funds. An investor receives payment for a redemption ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is a basis point (BPS)?

    A basis point is a unit of measure used in finance to describe the percentage change in the value or rate of a financial ... Read Full Answer >>
  4. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Full Answer >>
  5. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  6. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center