Ultra-Short Bond Funds
Not so long ago, when investors heard the word “bond,” they thought safety.
Fixed-income and bond strategies were considered nice conservative investments, but that was before Wall Street introduced an array of confusing products and securities that drew highly speculative, illiquid assets into a market that is normally a haven for risk-averse investors.
Ultra-short bond funds are not suitable for every investor, and some investors have experienced large losses due to the fraudulent sale of these funds. Brokers, investment advisers and their brokerage firms violate their fiduciary duties to customers when they recommend or sell investments that are not suitable for their clients’ goals and risk profile, and they can be held liable.
Any one of these ultra-short bond funds may be deceptively speculative. As the name suggests, an ultra-short bond fund invests only in fixed-income instruments with very short-term maturities. These are typically instruments with maturities of around one year.
Ultra-short bond funds tend to offer higher yields than typical fixed-income instruments like money markets, and they usually experience less price fluctuation than a typical short-term fund.
Investors would be wise to approach these investments with caution. The Financial Industry Regulatory Authority (FINRA) states in a regulatory notice that some investors fail to appreciate the difference between ultra-short bond funds and money market mutual funds.
Both of these products are mutual funds that generally invest in fixed-income securities with short maturities and have been described as “cash-enhanced” or “cash equivalents” in some cases.
The similarities end there. Unlike ultra-short funds, money market funds operate under a set of strict rules, according to FINRA. Money market funds may only invest in high-quality, short-term investments issued by the U.S. government, state and local governments and U.S. corporations. Money market funds are also are subject to strict diversification and maturity standards.
Ultra-short bond funds are not subject to these requirements. Their goal is usually to produce higher yields by investing in securities with higher risks. While a money market fund seeks to maintain a stable net asset value of $1 per share, the net asset value of an ultra-short bond fund is likely to fluctuate, FINRA says.
Unscrupulous or careless stockbrokers have marketed ultra-short bond funds as conservative when they are nothing of the kind. Sometimes brokers and their firms have relied on confusing language, such as calling these investments “cash equivalents.”
Much can go wrong with an ultra-short bond fund. During the credit crisis that began in 2008, some of these funds experienced dramatic increases in declines in their share price. While part of the blames falls on ratings agencies that gave the highest AAA rating to bonds tied to toxic sub-prime mortgages, the blame also lies with brokers and firms who sold these unsuitable products to investors who did not understand the risk.
Ultra-Short Bond Funds Gone Bad
As example of an ultra-short bond fund gone bad, witness what happened regarding YieldPlus, an ultra-short bond fund managed by Charles Schwab Investment Management, an affiliate of Charles Schwab & Company Inc. According to FINRA, Schwab made a drastic change in the fund’s holdings increased risk and price volatility by investing in the mortgage-backed securities market. But Schwab brokers omitted or provided incomplete or inaccurate information in both written materials and in conversations with customers relating to the fund’s risk, as well as its diversification. They continued to sell YieldPlus as a low-risk alternative to money market funds and other cash-equivalent investments. The fund lost almost 35% of its value. Schwab sold over $13.75 billion in shares of YieldPlus to customers. About 40 percent of these solicited sales were to investors who were 65 or older.
Schwab subsequently agreed to pay $18 million into a “Fair Fund” established by the Securities and Exchange Commission (SEC) to repay investors in YieldPlus. About $17.5 million of the $18 million payment was the disgorgement of fees that Schwab had collected for sales of the fund. Schwab was also fined $500,000.
Similarly, the Morgan Keegan Select High Income and the Morgan Keegan Select Intermediate Bond collapsed by more than 50% after the company, in an effort to reach for yields, loaded up the portfolios with exotic and illiquid asset-backed securities including highly risky collateralized debt obligations and home-equity loans.
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