Investing in ultra-short bond funds versus money market funds
Morgan Stanley Wealth Management04/26/23
Summary: Investors may turn to money market mutual funds to generate potential earnings on cash needed in a short time frame. Ultra-short bond funds are another investing vehicle that may offer modestly higher yields—but also higher risk. Learn the difference between the two products.
It’s a challenging time for investors looking to preserve capital and generate income. Between recent sharp rises in interest rates and volatility in the US stock market, there’s a lot to consider when thinking about what types of investments might help boost portfolio performance.
Ultra-short bond funds and money market funds are options to consider if you are looking for investments that could offer steady income and low risk relative to stocks and longer-maturity debt instruments. However, investors should be aware of how changing interest rates can affect their performance.
Here’s some of the things investors should know about these two types of investment vehicles.
Underlying investments tend to be short-term but vary in credit quality
Money market funds are a type of mutual fund that invest in very high-quality, short-term debt instruments, including US Treasuries and agency bonds (e.g., those issued by federally backed home mortgage companies Fannie Mae and Freddie Mac), as well as cash-equivalent securities, such as commercial paper and certificates of deposit. They pay out income that typically reflects short-term market interest rates. Because they can only invest in certain securities with very short maturities and high credit quality, they are among the least volatile investment vehicles. In fact, the daily pricing, or net asset value, rarely changes, but more on that later.
Ultra-short bond funds are mutual funds or exchange-traded funds (ETFs) that invest in short-term fixed income securities. However, ultra-short bond funds have more investment flexibility than money market funds and can invest in a broader universe of securities, including corporate debt, government securities, mortgage-backed securities, and other asset-backed securities in accordance with the terms of their prospectus. They generally have the freedom to invest in securities of longer maturity and lower credit quality, and as a result possibly provide higher yields.
Duration impacts response to interest rate changes
Duration is a measure of the sensitivity of the price of a debt instrument or bond to a change in interest rates. Generally, the longer a bond’s duration, the more sensitive its price is to changes in interest rates. Money market funds and ultra-short bond funds may have different durations, which in turn affects how they respond to changes in interest rates:
- Money market funds can only invest in securities with maturities of 13 months or less and the weighted-average maturity of the portfolio must be 60 days or less. The shorter duration of these securities means their prices are less sensitive to changes in interest rates than longer-maturing bond funds.
- Ultra-short bond funds can invest in bonds with varying maturities; however, the average duration of the funds tend to be around one year or less. While their duration could be longer than that of money market funds, it tends to be shorter than other short- or medium-term bond funds. In high-interest rate environments, ultra-short bond funds of certain types may be more vulnerable to losses if they have longer durations.
Net asset value impacts risk
Certain money market funds seek to maintain a $1 net asset value (NAV), which represents the per-share value of a fund’s assets minus its liabilities. Investors can generally sell their shares back to a money market fund on any business day at the NAV.
In order to maintain a stable NAV, money market funds may impose liquidity fees or redemption restrictions during times of market stress. Though extremely rare, in severe economic downturns, there have been instances when money market funds dipped below their $1 NAV, resulting in investors losing part of the principal value of their investment. This is referred to as "breaking the buck."
Ultra-short bond funds, on the other hand, have fluctuating net asset values based on changes in the value of the underlying securities, which means investors always run the risk of losing the principal amount of their investment.
Other details to know
Money market mutual funds, as well as ultra-short bond mutual funds only trade once a day when the market closes. Ultra-short bond ETFs, however, can be traded on an intraday basis.
The amount needed to invest in ultra-short bond funds and money market funds vary. Ultra-short bond ETFs generally require at least one share to be purchased, often starting around $50. Money market ETFs can typically require initial investments starting at $500.
Keep in mind, FDIC insurance does not cover money market funds or ultra-short bond funds.
Bottom line: Ultra-short bond funds may offer investors better potential yields than less risky money market funds. Investors should also be aware of the potential impact that changes in interest rates may have on the performance of these funds. The shorter duration of money market funds means their prices are less sensitive to changes in interest rates than longer-maturing bond funds. In high-interest rate environments, ultra-short bond funds may be extra susceptible to losses if they have longer durations.
Ultimately, though, the risks associated with a particular fund can depend on a variety of factors, so investors should be sure to read each prospectus carefully. As with any investment, keep in mind your risk tolerance and investment goals before considering either type of fund.
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