Short-Term Bond Funds Might Be Longer on Risk

To earn decent yields with “safety,” many investors have shifted cash to short-term bond mutual funds in recent years. The idea is logical enough: These funds are supposed to own corporate or government bonds maturing in two to four years, generally. You earn a better yield than a money market fund pays, while avoiding the extreme risks of longer-term bonds.

But here’s the problem: As short-term bond yields this year have fallen to their lowest levels in nearly three decades, many short-term funds have resorted to aggressive financial engineering to keep their yields up. Shareholders may be elated with the results so far--but few may understand the new risks inherent in these altered funds.

How do you know if your short-term bond fund is taking above-average risk? Currently, yields on two- to three-year U.S. Treasury or corporate bonds are in the 3.5%-to-5% range. So if your fund’s annualized yield is 6% to 7% or better, yet it claims to have an average maturity or “duration” of just two to three years, chances are you don’t own a plain vanilla, short-term fund.

That may not be a bad thing--so long as you approve of the fund manager’s new game plan.

Consider the $1.2-billion Strong Short-Term Bond Fund. In name, it’s a short-term fund. And the average maturity of its bonds is just 2.5 years. Yet the current annualized yield is 6.7%.

How does Milwaukee-based Strong do it? It owns a lot of higher-yielding, longer-term corporate and mortgage bonds, while at the same time using futures contracts to “short” longer-term Treasury bonds. One side of that equation is a bet on falling interest rates, while the other side is a bet on rising rates. The net result is to synthetically lower the “average” life of the bonds in the fund, while collecting a high yield.

Brad Tank, the Strong fund’s co-manager, also says that many of his bonds have floating rates--meaning they would eventually pay more if market rates were to rise. On the surface, at least, that’s an added plus for shareholders.

Nonetheless, Tank admits that the portfolio is structured to perform best in an environment of level or falling long-term interest rates. If long-term rates were to suddenly turn up, the value of the fund’s predominantly longer-term bonds could be clipped not only by the shift in rates, but also by any fresh worries about credit risk that might accompany that rate shift.

Thus, while plain vanilla, short-term funds are affected only by changes in short-term interest rates, it’s shifts in long rates that may most affect the Strong Short-Term fund--despite its name.

Another high-yielding short-term fund is the Scudder Short-Term Bond Fund in Boston. Manager Thomas Poor is generating a 6% yield, though the fund’s duration is just 2.2 years. (Duration isn’t average maturity, but it’s usually close.)

Poor’s fund is an eclectic mix of short- and long-term investments that includes Mexican debt, credit card receivables and so-called derivative securities--bonds whose yields ultimately are based on changes in another investment’s value, or even on an interest rate in a foreign country.

Wall Street has become extremely creative in recent years, producing hybrid bond securities that allow investors worldwide to position themselves on opposite sides of a specific rate bet. By selecting carefully and monitoring closely, Poor believes he has created a diverse portfolio of bonds and derivatives that can produce an above-average yield at relatively little additional risk.

Even so, many derivatives haven’t been tested by a market calamity. Poor worries about the proverbial other guy: “I do think there are more and more people getting into these things and taking risks that they’re not aware of.”

Can the typical short-term bond fund owner accurately judge the risk of his or her portfolio by looking over the fund’s investments? Doubtful. Many of the securities are practically listed in code.

Conservative investors should simply avoid high-yielding funds. Stay with lower-yielding funds that are more likely to be plain vanilla in scope, and whose risks therefore are more easily quantifiable--i.e., you might lose 2% of your principal if interest rates rise, but not 10%.

Two plain vanilla funds: Vanguard’s Short-Term Corporate, now yielding about 4.7%, and Twentieth Century’s U.S. Government, yielding about 3.8%. It may be hard to accept a lower yield, but if you’re risk-averse that’s really where you belong.

Bond Fund Risk: Not So Simple Anymore

Too many investors assume that bond mutual funds can be hurt only if interest rates rise. But interest rate risk is just one of five major risk elements your fund may face. The other four:

* Credit risk: The chance of default on some of the bonds or other securities in a fund.

* Currency risk: The risk of loss of value on foreign bonds in a fund if currency exchange rates fluctuate dramatically.

* Prepayment risk: The chance that high-yield bonds in a portfolio will be paid off early, possibly causing a taxable return of some of your principal.

* Structure risk: The risk of trouble in the so-called derivative securities sometimes used to synthetically alter the structure of a portfolio.