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Pulling the plug as ultra-short funds shrivel

The Baltimore Sun

When it comes to investing, there are times when boring is good, when the idea is to find a haven in a fund that does a simple job, easily and without flash, the kind of mutual funds you can hold without fear of what happens the next time you look at your statement.

For over a year now, however, investors who have parked money in ultra-short-duration bond funds have come away feeling like their investment vehicle has been vandalized while their cash was parked.

Over the past year, the average ultra-short bond fund is off 1.66 percent, according to Lipper Inc. Year-to-date, the situation is uglier, with the average fund in the category losing nearly 2.2 percent of its value.

For some funds, however, damages have been far worse. SSgA Yield Plus (SSYPX) is off nearly 30 percent in the past 12 months. Schwab YieldPlus (SWYPX) has lost more than 28 percent of its value, and Fidelity Ultra-Short Bond (FUSFX) has taken a 12.8 percent haircut.

For an ultra-short bond fund, that's as ugly as it gets. For investors, it's important to know how this happened and how a fund that is supposedly so safe can turn out to be so dangerous.

The cause of the problems should be obvious even to casual investors, namely the subprime credit crisis; the troubled ultra-short funds typically hold a big slug of asset-backed securities tied to the performance of the housing market.

When the housing market went into the tank, it took housing securities with it. Many institutional investors who had bought similar securities - including some hedge funds - had to either sell their paper or shut down; they opted for the former and flooded the market with notes, dropping prices even further.

Obviously, investors today recognize the danger in subprime asset-backed securities, but before all the trouble started, these securities were considered safe enough to fit into the investment profile of a risk-averse fund like an ultra-short. Money managers looking to squeeze some extra returns from the market went down the slippery slope toward subprime debt supported by the ratings agencies such as Standard & Poor's and Moody's, which had test-driven the securities and given them appropriate ratings. Managers thought they were within their designated safety parameters.

They were right until the subprime crisis became a headline, and the value of the paper cratered.

Mutual funds must "mark to market" every day, meaning they determine their price by figuring out what they could get if they had to sell everything in the portfolio at current prices. With the value of the ultra-short paper falling, the net asset values of the fund went along for the ride.

That, in turn, prompted fund investors to pull out, which made the situation even worse for some of the Yield Plus-type funds. Managers have no choice but to meet redemption requests; if the money going out exceeds cash coming in, securities must be sold. In ordinary times, it's no big deal, but with sellers flooding the market with this questionable paper - eroding its value that much further - managers who have been forced to sell have effectively locked in their losses.

Typically, the manager of a short-term bond fund would simply ride out a troubled bond, allowing it to mature in a few months and make the fund whole; ultimately, the risk of above-average losses would only occur, therefore, if issuers defaulted on the paper.

In the funds with the biggest losses, investors who are waking up to the problems now probably don't want to be the last ones out the door.

On the one hand, if the fund can avoid selling securities, the investor can hope that time passes, the paper stays out of foreclosure or default and the fund comes out whole; on the other, there's a good chance that fellow shareholders will bail out and leave you holding the bag.

The fund company could do that too. State Street Global Advisors has already announced plans to liquidate SSgA Yield Plus. Likewise, a few smaller issues in the category are pulling the plug, too.

Indeed, managers of any fund that combines "yield" and "plus" in its name must be wondering if they are better off killing a fund than living with a track record that could now be impaired for decades; as such, nervous investors may decide it's time to run to a covered parking spot for their cash, namely a money market mutual fund or a fund that buys only insured paper.

With the financial crisis yet to play out, be sure your next parking spot is a safe one, and consider looking for returns that are a bit more boring.

To get to that front edge of the performance pack sometimes means taking chances, and as the blown-up ultra-short funds have proved, that may not be worth the risk in today's market.


Charles Jaffe is senior columnist for MarketWatch and host of Your Money Radio. He can be reached by mail at Box 70, Cohasset, MA 02025-0070.

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