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Ultra-Short Bond Funds

- Alan Lavine and Gail Liberman

Looking to park some cash, but don't want to earn low money market fund yields?

Ultra-short term bond funds, though slightly riskier, may be the answer. These funds invest in short-term bonds that mature in three years or less. They yield at least 2 percent because they invest in corporate bonds with an average credit rating of AAA by Standard & Poor's, according to Morningstar Inc., Chicago.

U.S. government agency mortgage bonds make up almost one-half of the holdings of ultra-short bond funds.

Unlike money market mutual funds, which keep their share price at $1, ultra-short term bond funds can experience price fluctuations. Reason: Securities held by money funds are much shorter-term--typically 90 days or less.

Bond prices fall when interest rates rise, so the longer the bond security's term, the greater the price decline. Of course, the opposite also holds true if rates fall.

If interest rates rose 1 percent, the price of ultra short- term bonds would decline about .8 percent. But if, for example, you own an ultra-short term bond fund yielding 2 percent, the total return on your investment would be 1.2 percent. Total return factors the percent gain or loss in a bond's price plus the investment yield.

On the other hand, if interest rates rose 2 percentage points over when you bought a bond fund, you could lose principal. Interest income from an ultra-short term bond fund would not be enough to offset the loss in the value of the fund's bond holdings, so your total return would be in the red.

There are a couple of ultra-short term bond funds that invest only in adjustable-rate mortgage bonds. As rates rise, the yield rises, but the price should be steadier. Examples: AMF Adjustable Rate Mortgage Fund, Evergreen Adjustable Rate Fund and Federated Adjustable Rate Institutional Fund invest.

The best-rated ultra-short term bond funds that you can expect to fluctuate in price when interest rates change, according to Morningstar include: PIMCO Short-term Institutional Fund, Goldman Sachs Ultra Short Duration Government Fund, Dimensional One-Year Fixed Income Fund and Constellation CIP Ultra Short Duration Fixed Income Fund.

Be advised that economic forecasts call for three-month Treasury bills to rise to about 2.1 percent in 2005. Currently, U.S. Treasury bills yield about 1.2 percent. If the forecast is correct, you may not earn what you think you will earn in ultra-short term bond funds.


Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).

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