Is Your Short-Term Bond Fund More Risky Than You Thought?

With Bill Gross' departure from PIMCO--and the subsequent investor dollars flowing hither and thither--much of the drama in the fixed-income world has centered around core-type intermediate-term bond funds. 

But even as PIMCO, Janus, Metropolitan West, and DoubleLine have been grabbing headlines, there are few fund managers with a tougher row to hoe than managers of short-term bond funds. 

Most such funds are, by charter, constrained in how much interest-rate risk they can take on; for a fund to land in the short-term row of Morningstar's fixed-income style box, it must have a duration that is between 25% and 75% lower than that of the Morningstar Core Bond Index. 

Those mild interest-rate stances make it unlikely that short-term bonds will be unduly rattled in an interest-rate shock, which helps explain why inflows into short-term bond funds have been solid over the past few years. But their constrained maturities also mean that short-term bond fund managers have a limited tool kit for delivering a decent yield--or even a positive one. Three-year Treasury yields are currently under 1%, while the average expense ratio for funds in the group is 0.80%. (The average expense ratio for no-load shares is lower--0.60%--but still a hurdle.) For a fund to deliver a positive return, and certainly to produce a peer-beating one, a manager must either have the benefit of an ultralow expense ratio or be willing to venture well beyond Treasuries and into bonds with higher yields attached to them because their issuers are less creditworthy.

A handful of funds fall into the former camp--for example, the Silver-rated  Vanguard Short-Term Bond Index (VBISX). Although it includes a heavy component of government-backed bonds, its cheap price tag means that its yield has remained in the black even as yields have edged down. 

But several other short-term funds appear to be taking more credit-quality risk. That emphasis has paid off over the past six years as the economy has recovered, bond issuers have repaired their balance sheets, and defaults have declined. Senior analyst Sarah Bush says that no fund managers think a 2008-style credit crunch is in the offing. 

But, she notes, it's a good time to check up on bond funds' credit-quality exposures. "It's late in the credit cycle," she said, "and the surge in investor interest in the short-term bond space has put pressure on already low yields." If yield spreads were to widen out--that is, investors begin to demand a significantly higher yield on lower-quality bonds than they do today--investors who own junky, short-term bond funds could see losses. Not only could the prices of low-quality bonds fall, but low yields mean that there would be just a limited cushion if they do. A lot of credit sensitivity may not be what many investors had in mind when they bought a short-term bond fund. 

To help identify short-term bond funds that are taking a fair amount of credit risk at this juncture, I used  Morningstar's Premium Fund Screener. I screened for short-term bond funds with an average credit quality of "low" or a weighting of 15% or more in bonds rated BB, the highest-quality tier of the junk-bond universe. Premium users can click  here to run the screen themselves or tweak it to their own specifications. 

Several of the funds on the list are tiny, but a handful have sizable asset bases. Below, you will find overviews for two of them.

 BlackRock Low Duration (BFMSX)
This fund performed terribly during the financial crisis, when a basket of non-agency residential and commercial mortgage-backed bonds spelled trouble; the fund lost 9% and landed in the bottom 25% of the short-term bond category. Senior analyst Eric Jacobson says that the fund re-tooled its management and analyst team and process in the wake of those troubles; tightening up risk controls was a central thrust of the changes. The fund's results have been stellar since. While it struggled a bit during the credit crunch in 2011's third quarter, Jacobson says it didn't perform much worse than the category average. That said, its stake in non-investment-grade bonds is at the high end for the category--19%, according to the most recently available information on BlackRock's site--and its stake in bonds rated BBB is also quite high relative to the category norm. 

 Lord Abbett Short Duration Income (LALDX)
This fund has been an asset-gathering machine over the past several years: With $38 billion in assets, it's now more than twice the size of  Fidelity Magellan (FMAGX). Investors have clearly been attracted to its yield--nearly 4% in a category where 1% and 2% yields are the norm--as well as its string of stellar calendar-year total returns. Senior analyst Cara Esser says the fund benefited from near-perfect timing: Long focused on government bonds, it took on a broader mandate and adopted a more credit-sensitive profile in December 2007. As the economy recovered in 2009, such bonds soared. Esser notes that sizable positions in commercial mortgage-backed securities and low-quality bonds contribute to its high yield relative to its peer group; as of Sept. 30, the fund had 28% in the former and 24% in the latter. 

Takeaways
This is not to suggest that these funds' fortunes will reverse overnight. The U.S. economy appears to be relatively robust and corporations have shored up their balance sheets, so it's conceivable that investors could remain in "risk-on" mode for the foreseeable future. And even in a flight to quality, it's possible that short-term bond-fund managers who are embracing credit-sensitive bonds today could retreat to higher-quality bonds in time to reduce the damage. 

But given that many investors use short-term bond funds to defray near-term income needs, some of these funds could be taking more risk than their shareholders bargained for. Given the duration of the current rally in lower-quality bonds, it's a good time to pre-emptively check up on your holdings' credit-quality exposures. And if a fund has a substantially higher yield than its peers, be sure you understand what it's doing to generate it.

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