Ultra-short bond funds and money market funds: Know the difference

Money market funds can be used to boost the yield on cash needed for near-term use, or for the more conservative part of a portfolio. But with interest rates so close to zero, investors are likely in search of higher yields. Enter ultra-short bond funds. These funds may produce higher yields than money market funds with relatively low volatility.

While both products are considered low risk, there are significant differences between the two that investors should know.

Money market funds are a type of mutual fund that invest in very high-quality, short-term debt instruments including US Treasuries and agencies (e.g., Fannie Mae and Freddie Mac), and 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.

By law, 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. This typically means they are less vulnerable to interest rate risk 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.

Remember, the longer the duration, the more sensitive to changes in interest rates.

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 where 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, which means investors always run the risk of losing the principal amount of their investment. 

The amount needed to invest varies depending on the fund. Ultra-short bond ETFs generally require at least one share to be purchased, often starting around $50.

Ultra-short bond mutual funds, as well as money market mutual funds, only trade once a day when the market closes. Ultra-short bond ETFs, however, can be traded on an intraday basis.

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 money market funds with less market risk than short-term bond funds with longer maturities. 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.