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'Money Market Substitutes' Get Hit by Subprime Woes

Subprime woes claim a category thought to be low-risk.

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So much for money market substitutes. There have been a number of articles over the years about using short- or ultrashort-term bonds as money market substitutes. Yields on money market funds are typically low so it's understandable that you might want to boost income by moving to ultrashort- or short-term bond funds, which sometimes have a higher yield.

However, the subprime mess may forever dispel investors of that notion. Ultrashort is supposed to be the most conservative, low-risk bond fund around, yet a number of funds are in the red for the trailing four months and even the year. Consider that ultrashort has been about the worst place to be for the past four weeks. Through Friday, the average ultrashort fund is down 0.36%, versus gains of 0.37% for short-term bond funds, 0.37% for intermediate, and 0.16% for long bond funds. Only high-yield, emerging markets, and bank-loan funds have fared worse.

The category truly has the lowest risk when it comes to interest-rate risk as its funds have the lowest duration of any taxable funds around. We define ultrashort bond funds as those with durations of less than a year. Because they are naturally owned by investors with pretty short-time horizons most of the funds don't take on much credit risk. However, ultrashort bond funds are allowed to take on more credit risk than money market funds, and some do so. Moreover much of the subprime bonds these funds own are actually rated AA or AAA, so the risks didn't seem like all that much until now.

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Russel Kinnel does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.