Bond Funds That Are All Defense

The article was published in the September 2021 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting the website.

The prospects for investors seeking income within the relative safety of the ultrashort bond Morningstar Category have been muted for the past few years. This is largely by design, as the very traits that make ultrashort bond funds attractive in both rocky credit markets and rising rate environments also put a damper on their yields.

Investors may find themselves attracted to ultrashort bond funds for a number of reasons. At a time when most savings and money market accounts have yielded close to zero for a number of years, the incremental yield offered by a "cash plus" ultrashort bond fund could be attractive to the investor seeking a place to park cash for a period of time. On the other hand, with many intermediate core bond category funds posting duration figures approaching multidecade highs, investors interested in broad fixed-income exposure may find themselves attracted to an ultrashort bond fund simply to lower their interest-rate risk. If investors stay cognizant of these funds' distinct profiles relative to other fixed-income funds and to one another, ultrashort bond funds can be valuable portfolio building blocks in a variety of market environments.

Ultrashort bond funds invest largely in investment-grade fare (though some will invest modestly in high-yield debt) and have an effective duration, a measure of interest-rate risk, 25% or less than the three-year average effective duration of the Morningstar Core Bond Index. In practice, most ultrashort funds post duration figures of less than one year and prove far more resilient in rising rate environments than their counterparts farther up the maturity ladder. When yields spiked in the first quarter of 2021, the average intermediate core bond fund posted a 2.9% drop, whereas the average ultrashort bond fund eked out a 0.2% gain.

Though ultrashort bond funds are also defensive performers in rocky credit markets, the degree of variability here is greater and depends on how each portfolio manager approaches positioning. While many ultrashort bond funds invest almost entirely in high-quality U.S. Treasuries, agency mortgages, and investment-grade corporates, some up the ante with high-yield bonds, emerging-markets debt, and esoteric securitized credit. This can help boost yield but can also cause pain in downturns. The severe pandemic-related sell-off from Feb. 20, 2020, through March 23, 2020, saw the average ultrashort strategy post a 2.9% loss, less than the drops experienced by longer-dated and lower-credit-quality strategies but still a significant shock for those treating their ultrashort allocations as ballast, if not an outright cash substitute, within their broader portfolios.

Two ultrashort bond strategies illustrate the category's relative risk and rewards: Fidelity Conservative Income Bond FCONX and Pimco Short-Term PSHAX. Both have Morningstar Analyst Ratings of Bronze for their sensible investment processes, experienced managers, and robust supporting resources, yet they offer different risk profiles. The Fidelity fund is a cash substitute that focuses almost exclusively on investment-grade U.S. corporates and Treasuries, whereas the Pimco fund has dipped into high-yield credit, emerging markets, and derivatives to gain an advantage.

During the largely credit-risk-friendly market of the past decade, Pimco Short-Term's tactics won: Its 1.7% 10-year annualized return through September 2021 edged Fidelity Conservative Income Bond's 1.1%. But the Fidelity fund remains a compelling option when credit markets tumble: In 2020 from Feb. 20 through March 23, it lost a modest 1.9%, while Pimco Short-Term dropped by 3.7%.

Picking between these two ultrashort bond funds, let alone the broader category universe, depends on what you need your ultrashort bond fund to do. Investors who are looking for a true "cash-plus" vehicle and are willing to forgo some potential income may wish to stick with a fund like Fidelity Conservative Income Bond. Those who are focused on an ultrashort bond fund's resilience in interest-rate shocks and don't mind a little more volatility may prefer Pimco Short-Term.

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