As Rates Rise, Short-Term Bond Funds Beckon

After nine months of interest rate hikes, the yields from money market mutual funds are starting to look attractive again. But for investors who can accept a bit more risk, ultra-short-term bond funds may offer a better deal.

These vehicles boldly go where money funds can’t: into government and corporate IOUs that come due more than 13 months down the road.

The Securities and Exchange Commission requires money market funds to keep their overall holdings very short-term to ensure that they remain conservative. The rationale here is simple: Debt instruments with lengthier maturities are more volatile.

Although money funds may own individual IOUs that are due in as many as 13 months, they’re required to keep their overall portfolio mix much closer to home. A money fund’s average holdings may not exceed 90 days.

Practically speaking, however, a debt instrument maturing in 13 months or even two years isn’t all that much riskier. And, to compensate for the added danger, short-term bond funds pay higher yields.

“When the SEC adopted these rules (in the early 1980s), they created a pocket of inefficiency right beyond where the money funds can invest,” said Richard Strong, head of the $11-billion Strong Funds group of Milwaukee. “It’s an area where there aren’t many natural buyers.”

Currently, short-term bond portfolios are paying about 6% on average, compared to about 4.5% for money funds.

The short-term bond funds also have the potential to generate modest capital gains (or losses), which the money portfolios don’t.

But the SEC regulations explain only part of the yield differential between the two types of mutual funds. Another key factor is the investor’s willingness to accept lower yields in return for the principal stability available on money funds, said Tad Rivelle, a manager of the Hotchkis & Wiley Low Duration and Short-Term Investment funds in Los Angeles. Principal loss is always a minor risk in short-term investments.

“This is a reflection of the public’s risk aversion,” he said.

During periods when interest rates are being ratcheted up, money market funds offer the best protection. But most of the time, the short-term bond portfolios with their higher yields generate superior returns.

Which type of fund should you favor? That depends on your interest rate outlook.

Frank Rachwalski, a senior vice president who oversees 14 money market portfolios with $12 billion in assets for Kemper Financial Services in Chicago, anticipates another wave of rate hikes. He predicts that money fund yields could top 6% by the end of next year and that 30-year Treasury bonds could be paying 9%, up from about 8% today.

“Everything is in place for rates to go higher,” Rachwalski said, citing U.S. economic strength, an export uptick, improving foreign economies and inflationary pressures.

Rivelle predicts rates will continue rising, but more slowly and by smaller amounts than they have so far in 1994. Strong, too, believes the worst is over. Unless interest rates rise sharply from here, they say, the short-term bond funds will outperform their more conservative cousins.

When shopping for short-term bond funds, it’s important to look at the “load,” or sales commission, if any, as well as the fee for annual operating expenses. High loads and expenses eat into returns and are hard to justify considering the modest yields these investments pay out.

The most competitive short-term bond funds are commission-free and charge 0.5% or less for annual operating expenses.

Investors seeking long-term growth wouldn’t want to park too much money in short-term bond funds. These investments won’t make you rich. All you can really hope is that they will stay two or three percentage points ahead of inflation each year.

Even that’s better than what money market portfolios have historically delivered. And at yields of 6% or so, the short-term bond funds are starting to look good again.

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Warburg Pincus Japan OTC, the first actively managed mutual fund to focus on smaller Japanese stocks, has garnered $20 million in assets in its first month of operation.

Smaller companies have long been overshadowed in Japan by the large, export-driven multinationals. But the smaller firms will enjoy better profits and investment performance with the yen at its recent high levels, predicted Shuhei Abe, the Tokyo-based manager of the Warburg Pincus fund ((800) 888-6878; no load).

Smaller Japanese companies tend to concentrate more on the domestic market than on exports, and a theme Abe likes here is discount retailers.

“Companies that challenge the inefficient pricing widespread in Japan will be big winners,” he said.

Abe predicts smaller stocks will outperform the blue chips for several years, helped by an expected rebound in Japan’s economy. And such stocks are cheaper than shares in large firms.