SAN FRANCISCO (CBS.MW) -- Just when U.S. investors were getting pumped about stocks, the market tanked.
This nervous market has given up this years gains on a host of bad news: Terrorism and a torn economy casts a grim shadow. The Bush administration is ripped for obsessing on Al Gore and dismissing Al-Qaida. Medicare is gravely ill. Rocketing fuel prices have siphoned half of the $60 billion in coming tax rebates.
Okay, maybe its time to pocket some of 2003s profits, especially since cash is comfort food for uncertainty.
Conventional wisdom recommends shifting into government and corporate bonds to reduce stocks higher risk. With inflation still surprisingly low and the Fed expressing patience about interest rates, bonds this year are trouncing stocks. Long-term, government-bond mutual funds are up 6 percent, while small-cap value funds top all diversified stock-fund categories with a meager 2 percent gain.
Yet, unless Treasury yields drop further from already generational lows, long- and intermediate-term bonds pose huge potential downsides. When yields rise and bond prices fall, longer-maturing bonds are hit hardest.
Some shoppers are moving to cash. Our capital is underutilized now, but that will happen periodically, Warren Buffett wrote last month in his 2003 letter to Berkshire Hathaway shareholders. Its a painful condition to be in -- but not as painful as doing something stupid. (I speak from experience.)
Underutilized capital can find a haven in ultrashort bond funds that invest in government, corporate and mortgage debt due within 12 months on average. Accordingly, this pinpointed portfolio has advantages over both longer-maturing bond funds and money funds.
Specifically, ultrashort funds yield more than money markets but less than short-term bond funds. At the same time, credit and interest-rate risk is lower than other bond funds. If the Fed loses patience and interest rates move higher, ultrashort funds absorb the pain without much principal loss.
If youre looking to get out of the stock market but youre uncomfortable with the interest rate- and credit risk of a typical bond fund, an ultrashort fund will be a good choice, says Mark Riepe, head of the Schwab Center for Investment Research.
Flexibility and liquidity make ultrashort funds a good parking spot for living expenses and emergency money that isnt needed day-to-day.
Ultrashort funds equate to long-term cash, Riepe adds. Youll have much less maturity risk and typically less credit risk, but you arent giving up the yield that you would with a money-market fund.
Money-market yields nowadays dont begin to outpace inflation. Taxable money funds returned 0.6 percent for the year through February and 1.6 percent annualized over three years, according to iMoneyNet, a money fund data provider. Near-zero risk is attractive, but sub-zero returns after inflation is downright chilly.
Ultrashort funds, by comparison, gained 1.9 percent over the past year and 3 percent annualized over three years, reports investment research firm Morningstar.
Short-term bond funds produced better returns during those periods of 3.5 percent and 4.6 percent, respectively, but with additional risk.
Theyre that sweet spot between money market funds and short-term bond funds, where you dont have too much extra risk and yet can add a little more yield, iMoneyNet Managing Editor Peter Crane says of ultrashorts appeal. If you have six months to a year as a savings horizon, it may be worth taking that little extra risk.
More damaging to ultrashort funds than Fed rate hikes are high expenses and onerous sales charges.
Morningstar says ultrashort funds expenses average 0.8 percent, a huge chunk of their gains. Some broker-sold products also saddle shareholders with 12b-1 sales fees and front-end loads.
For example, Pimco Short-Term PSHAX,
Morningstar fund analyst Scott Berry recommends two ultrashort funds with high-quality holdings to mitigate risk and below-average expenses that maximize returns.
Fidelity Ultra-Short Bond FUSFX, with a 0.55 percent expense ratio, keeps interest-rate sensitivity to about six months and mostly A-rated credits in its $390 million portfolio.
The Fidelity fund is less than two years old, but Berry calls it a good place to start. The fund rose 2.1 percent in the last year, in the top third of its peer group.
SSgA Yield Plus SSYPX, with a 0.58 percent expense ratio, is Berrys other favorite ultrashort vehicle.
The no-load fund rose 1.7 percent in the past year, squarely in the middle of its peers. But its management team invests roughly 70 percent of the $268 million portfolio in triple-A rated credits and interest-rate sensitivity is a bare minimum.
Investors are looking at this group for safety, Berry says, and those two certainly provide it.
Better than money in the bank.
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