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Ultrashort-Term Bond Funds Suffer Massive Blow

Unexpected blowup threatens this category's existence.

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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 (FUSFX) and  Schwab YieldPlus (SWYPX).

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.

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