Ultra-short Bond Fund- Everything You Need to Know

  • Bhumika Dutta
  • Nov 08, 2021
  • Financial Analytics
Ultra-short Bond Fund- Everything You Need to Know title banner

Introduction to Bond Fund

 

A bond fund, sometimes known as a debt fund, is a collective investment option that invests primarily in government, municipal, corporate, and other debt instruments, such as mortgage-backed securities, in the field of finance (MBS). The basic purpose of a bond fund is to provide investors with monthly income. 

 

There are long-term bond funds and short-term bond funds available in this system but, a long-term bond has a higher interest rate risk than a short-term bond due to the inverse connection between interest rates and bond prices. In this article, we are going to talk about Ultra-short Bond Funds. 

 

(Also read: What is Reverse Mortgage?)


 

What is the Ultra-short Bond fund?

 

A bond fund that invests exclusively in fixed-income assets with very short maturities is known as an ultra-short bond fund. It will invest in instruments with a one-year maturity or less. Due to their short maturities, these funds have greater flexibility and may often seek higher returns by investing in riskier securities than regular bond funds. 

 

These portfolios have limited interest-rate sensitivity and hence reduced risk and total return potential due to their emphasis on bonds with relatively short maturities. This approach, on the other hand, has a larger yield than money market instruments and less price volatility than a standard short-term fund. Certain forms of ultra-short bond funds may be more vulnerable to losses in high-interest rate settings.

 

Ultra-short bond funds are neither covered or guaranteed by the Federal Deposit Insurance Corporation (FDIC). According to Morningstar, Ultrashort is defined as 25% of the MCBI's average effective duration over three years.

 

(Suggested read: Types of bonds)

 

How does an Ultra-short Bond Fund work?

 

Longer-term bond investments provide less protection against interest rate risk than ultra-short bond funds. Because these funds have such short maturities, interest rate hikes will have less impact on their value than a medium- or long-term bond fund. 

 

While this approach provides more protection against increasing interest rates than other money market instruments, it also carries a higher risk. 

 

Furthermore, whereas certificates of deposits (CDs) are subject to investment requirements, an ultra-short bond fund is not subject to any additional restrictions than a traditional fixed-income fund.

 

According to this article written by sterling capital:

 

  • Under normal circumstances, the Fund invests at least 80% of its net assets plus borrowings for investment purposes in fixed income securities to achieve its investment goal (bonds).

  • The Fund's average term will be 18 months or less, and its average maturity will be between zero and 24 months.

  • The portfolio manager adopts a "top-down" investment management method to manage the portfolio, concentrating on sector allocation, credit risk, and individual security selection. (Related reading: Portfolio Management)

  • He/She looks at macroeconomic developments to determine a duration objective that represents the forecast for interest rates in the future.

  • To control the yield curve, various factors such as future inflation forecasts, supply factors, and future interest rate expectations are taken into account.

  • The portfolio manager's macro outlook on interest rates and volatility, as well as relative spread analysis, are used to determine sector weightings.

  • He then picks individual shares that are compatible with the aim using fundamental research, looking for the greatest relative values within certain sectors.

  • An attempt is made to comprehend the structure and embedded properties of possible securities as part of the study. 

  • Puts, calls, sinking fund requirements, prepayment and extension risk, and specific company financial data for possible corporate ownership are all considered. Scenario analysis is the most common method used in these evaluations.

 

(Must read: Types of financial risks)

 

Credit Quality of Ultra-short Bond Funds:

 

Investopedia writes in its article that, because a credit downgrade or default of portfolio assets might result in losses, investors should examine the sorts of securities in which an ultra-short fund invests. 

 

Credit risk is less of a concern for ultra-short funds than it is for standard bond funds since short-term bonds expire fast. If a fund invests mostly in government securities, this risk is considerably decreased.

 

Ultra-short bond funds, on the other hand, should be avoided since they invest in bonds from firms with worse credit ratings, derivative products, or private-label mortgage-backed securities to increase yield. Those funds are more likely to have greater degrees of investment risk. 

 

Always be wary of any investment that claims to offer you a higher return with no added risk. Investors may learn more about an ultra-short bond fund by reading the prospectus and other accessible materials.

 

Date of Maturity of the Fund’s investments:

 

The maturity date of a security is the day on which it must be paid. If the funds are generally comparable, an ultra-short bond fund that has assets with longer average maturity dates will be riskier than one that contains securities with shorter average maturity dates.

 

Sensitivity to Interest Rate Changes:

 

When interest rates rise, the value of debt securities tends to fall. As a result, an investor who has invested in any bond fund, including ultra-short bond funds, may end up losing money. Certain ultra-short bond funds may be more sensitive to losses in a high-interest rate environment. 

 

Before investing in any ultra-short bond fund, it's critical to learn about the fund's duration, which reflects how sensitive the fund's portfolio is to interest rate changes. Investors may learn more about an ultra-short bond fund by reading the prospectus and other accessible materials. 

 

Before investing in an ultra-short bond fund or any mutual fund, investors should understand how mutual funds & function, what aspects to consider, and how to avoid frequent pitfalls.
 

Examples of Ultra-short Bond Funds:

 

Some examples of Ultra-short Bond Funds are:

 

  • SPDR Blmbg Barclays Inv Grd Flt Rt ETF (FLRN)

  • iShares Floating Rate Bond ETF (FLOT)

  • VanEck Vectors Investment Grd Fl Rt ETF (FLTR)

  • iShares Short Treasury Bond ETF (SHV)

  • SPDR Blmbg Barclays 1-3 Mth T-Bill ETF (BIL)

 

Drawbacks of Ultra-short bond funds:

 

In theory, ultra-short bond funds are likewise highly secure investments, but they have downsides that money market funds do not have. 

 

  • Many of those portfolio bonds have coupon rates that are greater than current interest rates during periods of extremely low market interest rates. A premium bond has a higher coupon rate than current interest rates since its price is more than par, or the bond's $1,000 face value. 

  • If the bond is held to maturity, the higher price paid when it is bought into the portfolio is more than the principal earned at maturity, resulting in a principal loss. Greater interest payments can compensate for the loss of principle, resulting in a higher overall return on investment than money market funds.

  •  Some ultra-short funds look for greater returns on corporate bonds or bonds that are susceptible to economic downturns. During the 2008 credit crisis, certain ultra-short bond funds underperformed, losing up to 20% of their value.

 

(Also read: Types of Credit Derivatives)


 

Ultra-short Bond Funds Vs Low-Risk Investments:

 

Now that we understand everything about Ultra-short bond funds, let us learn how it is different from other low-risk investments. The distinctions between ultra-short bond funds and other low-risk fixed-income assets like money market funds and certificates of deposit (CDs) are significant. 

 

Money market funds, for example, are limited to high-quality, short-term assets issued by the federal government, enterprises in the United States, and state and local governments. Ultra-short funds, on the other hand, have greater flexibility and often seek larger returns by investing in riskier securities. Ultra-short bond funds' net asset values (NAV) can vary. 

 

Money market funds, on the other hand, strive to maintain a constant NAV of $1.00 per share. Money market funds must also meet stringent diversification and maturity requirements. These rules, however, do not apply to ultra-short bond funds. Furthermore, ultra-short bond funds are neither covered or guaranteed by the Federal Deposit Insurance Corporation (FDIC). 

 

On the other hand, a certificate deposit is insured up to $250,000. CDs, which offer a return of principal and a fixed rate of interest since they are held by a bank or thrift institution, are covered by the FDIC. In addition, CDs usually provide a higher interest rate on deposited cash than a traditional savings account.


 

Conclusion

 

The Ultra-short bond fund is susceptible to the same risks as the portfolio's underlying bonds, including credit, prepayment, call, and interest rate risk, as discussed earlier. Bond prices will fall in value as interest rates rise. 

 

The fund may make more high-stake investments, such as foreign securities, which may introduce the fund to currency and exchange rate fluctuations; mortgage-backed and asset-backed securities that are sensitive to interest rate fluctuations; and high yield debt (also known as junk bonds), all of which may cause greater volatility and less liquidity. 

 

(Must catch: What is a Debenture?)
 

Investors need to be skeptical of funds that promise high returns with no risks whatsoever. Thus, this article informs the mass about Ultra-short Bond funds.

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