Fidelity Ultra-Short, Schwab Yield Plus and SSgA Yield Plus Losses

Ultrashort bond funds don’t take on much interest-rate or credit risk and their returns are a bit better than traditional money market funds so they have historically been considered an investment superior to money market funds. That’s why it is so surprising that since the credit crisis began last year the bond funds’ performance started sliding and a few funds in the group have blown up.

It turns out that the root of this debacle is that many ultrashort funds have securities tied to the performance of the housing market and the funds plunged as the housing market plummeted.

To make matters worse, many investors who owned these securities had to sell them, which further brought down the prices and reduced the funds’ chances of a quick recovery. Increasing redemptions have caused funds like Fidelity Ultra-Short, SSgA Yield Plus and Schwab YieldPlus to drop 13% to 27% in value and SSgA has decided to liquidate Yield Plus. In order to fulfill redemptions, fund managers have to keep cash handy and to do that, they have to sell securities to have enough cash for outflows. But the markets for ABS and MBS bonds froze last summer with sellers far exceeding buyers, forcing prices even lower and losses higher.

So why did these supposedly safe and high quality funds own such risky investments?

Ratings agencies like S&P, Moodys and Fitch had tested out various bonds using logical default risk assumptions and the results showed these securities offered decent yields. For example, the most secure groups of loans in subprime ABS offered yields that were only 0.05% higher than the three-month LIBOR, which was 5.3% to 5.4% during the first half of 2007. That was considered relatively safe but it wasn’t. Recently, that yield spread expanded 3.5% to 5.5% above LIBOR and prices have dropped in proportion.

This downturn highlights the weakness of ultrashort funds. Their goal is to exceed money market returns without being much more risky. Unlike money market funds which are restricted to certain investments, ultrashort funds can target relatively safe short-term bonds with good total-return potential that are off-limits to money markets. But when these targets aren’t available, ultrashorts can’t beat money markets. Also, to keep up the reputation of their money markets, many companies (such as Legg Mason, Northern Trust and SEI) would infuse their funds with capital if their money markets are at risk. Ultrashort funds have no such life savers.