Unexpected blowup threatens this category's existence.
The ultrashort-term bond category has taken a massive blow, and recovery for many of the hardest-hit funds falls somewhere in the range of doubtful to impossible. In a category where only a few basis points tended to separate the leaders from the laggards and losses had been small, the category's worst performers have lost between 10% and 30% over the past year. That, from funds sold as a cash alternative, is downright astounding. Unfortunately, the worst returns have come from some prominent fund families and funds with the most assets, including Fidelity Ultra-Short Bond
We can't say that we saw this coming. We didn't. There were risks in these portfolios that were hard to see and had never materialized in the past, so backward-looking risk measures such as standard deviation and past losses proved unreliable. Given the near-term maturities of the bonds in the portfolio, we underestimated the damage that subprime and other low-quality bonds could cause. A few other things stood in the way of careful analysis, too. Many of these security types did not have long histories. The mortgage-backed securities market didn't take off until the 1980s, for example, and it has never hit times like this. The credit ratings agencies also failed. The other risk that started feeding on itself was the effect of shareholder redemptions: The unexpected extent of losses led fundholders to redeem their shares, which forced the managers to sell securities at deep discounts, which led to further losses, leading to further redemptions, and so on.
This situation has, however, served as an important lesson overall. For one, it underscores the fact that there is no free lunch. With added yield comes added risk, bottom line. Moreover, it is critical to think about and watch closely the effect that a bank run can have on a fund and stay alert to signs that one might be under way.
The selling point of these funds is greatly diminished. They were sold as cash alternatives that would provide a little more yield with a little added risk. It will be hard for investors to buy into that risk/reward promise again. The category is shrinking as a result; investors continue to redeem their shares, and SSgA Yield Plus and Evergreen Ultrashort Opportunities have liquidated in recent months. We fully expect that others will follow, considering that returns have continued to suffer. The latest performance casualties in the category have been two AMF funds: AMF Ultra Short Mortgage
We continue to recommend a few funds in this category, but investors looking for the stability that the group was known for should look elsewhere at this point.
Karen Dolan is director of fund analysis with Morningstar.
Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.
Get mutual fund and stock information from our analyst team delivered to your e-mail inbox every Tuesday. Sign up for our free Investment Insights e-newsletter.