An Ultra-short Bond Fund Can Give You The High Income You Need
You may be getting your earnings income from CDs or money market funds but you're still looking for even higher interest earnings
. If so, try an Ultra-Short Bond (USB) fund for higher interest rates but at a somewhat greater risk. A USB fund invests only in fixed-income instruments with very short-term maturities - about 1 year. It seeks higher yields than money market funds but with less price fluctuations than a typical short-term (1-3 years) bond fund.
The USB is a mutual fund. So, like other bond mutual funds, it invests in a wide range of securities, including corporate debt, government securities, mortgaged-back securities, and other asset-backed securities. But it carries more risk than most money market instruments and it's not insured by the FDIC or any other government agency. A CD, on the other hand, carries federal deposit insurance up to $100,000. But, of course, the USB's greater risk will bring a greater interest return.
One aspect of the USB is a more reliable income projection. That's because the very short duration of an ultra-short bond, reduces its value's dependence on changing interest rates since it's so close to maturity. The short duration also reduces the time for any default to take place - a strategy to minimize your risk.
But all USB funds are not the same. They vary significantly in their risks and rewards. Here are some factors associated with risk when you evaluate these funds for possible investments:
*The fund's credit quality:
Those USB funds that secure higher interest rates by investing in bonds of companies with lower credit ratings, derivative securities, or private label mortgage-backed securities are necessarily subject to a higher level of risk than those that principally invest in lower-interest rate government securities.
When the underlying investments of a USB fund do default or become more precarious, the fund's credit quality will be downgraded. This means the fund's value - and your share holdings - will drop. *The fund's duration:
The duration of a fund is the average time to maturity of its holdings. At maturity, the company must redeem the bond - if it can - buy paying the bond holder the face value of the bond.
Though these funds are made up of short duration bonds, some funds have longer durations than others. Funds with a longer average time to maturity (duration) are more vulnerable to default risk than are funds that are otherwise similar in their portfolio makeup.
*The funds's sensitivity to interest rate changes:
In general, as interest rates go up, the value of debt securities goes down. This is reflected in all bond funds, and the longer is the time to maturity, the greater is the decrease in its value for a given rise in interest rates. That's because the worth of an underlying bond's value must decrease to make whatever fixed interest rate it does pays competitive (percentage wise) with those new higher fixed interest rates bonds.
Contrarily, the shorter the duration (average time to maturity), the less sensitive is the fund's value to interest rate changes. So those USBs with the shortest durations will more easily resist a value change when interest rates change.
So, when checking out a possible USB fund, be sure to find the fund's duration; the shorter it is, the less sensitive it is to default and interest rate changes.
by: Shane Flait
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