A ‘Short Cut’ To Higher Yields

As interest rates are cut, investors can capitalize on short-term bond funds

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The Federal Reserve’s repeated interest-rate cuts may eventually shock the economy back to life and rejuvenate the stock market. In the meantime, though, yield-oriented investors are paying the price. “At the beginning of 2001, the average money market fund was yielding around 6%,” says Peter G. Crane, vice president and managing editor at iMoneyNet Inc. in Westborough, Massachusetts. “Since then, the average yield has fallen to 3.5%, and further declines are possible.”

If that 3.5% seems skimpy to you, you can find higher yields in ultra-short and short-term bond funds. Ultra-short bond funds currently have average maturities of 2.5 years, according to Morningstar Inc., the mutual fund tracking company in Chicago, and average yields of 6.6%. Short-term bond funds have average maturities of 3.5 years and average yields of 5.9%. Short-term government bond funds have average maturities of 4.2 years and average yields of 5.5%.

But how much risk are you taking with a short or ultra-short fund? One way to tell is to track a fund’s performance over time. Among ultra-short funds, Scott Berry, an analyst at Morningstar, favors Strong Advantage Investor (STADX). In the past 10 years, this fund’s share price has fluctuated between $9.88 and $10.19 per share, a fairly narrow band. If you can tolerate such volatility, you stand to reap a high yield: Strong Advantage was paying 6.6% recently.

One reason for such a high yield is that Strong Advantage invests in short-term corporate debt, where yields are relatively high. “You’re getting high yields, but you’re also taking credit risks with such a fund,” says Roger Van Pelt, director of planning with Tyler Wealth Counselors of West Chester, Pennsylvania.

Van Pelt says he prefers Vanguard Short-Term Treasury (VFISX), which holds only short-term obligations of the federal government. “For true diversification away from the stock market, we recommend funds such as this one, which holds no corporate debt. Like all Vanguard funds, the expense ratio is extremely low (0.27%), and in a bond fund, a low expense ratio is a key factor in greater returns,” he says. This Vanguard fund’s share price fell to $9.79 in 1994, a rough year for the bond market, but since then has ranged between $10 and $10.37. Recently, the yield was 5.7%; and because the interest comes from U.S. Treasury securities, it’s exempt from state and local income tax. (To find top short-term bond funds, based on one-year total returns, see chart on this page.)

Your personal situation can help you decide whether to invest in short or ultra-short funds, according to Crane. “If you think you might need cash right away, stay with a money market fund,” he says. “Don’t risk losing principal just to increase your current yield. However, if you don’t expect to need cash for a year or more, you probably can increase your return by moving into a fund with slightly longer maturities of between two and five years.”

Moreover, short and ultra-short funds may make ideal “parking lots” for money you eventually tend to invest. “You could park the

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