A Better Bet Than Money Markets?

Short and ultrashort bond funds have higher yields

Jan van Mourik has watched his equity portfolio tank by 30% in the past two months and, by all rights, shouldn't be in the mood to take on more risk. Still, the 37-year-old database administrator for SynQuest in Clifton Park, N.Y., puts in $1,100 each month, mostly into tech stocks. He does keep an emergency cash cushion in a money-market fund, but it's just $1,500. That could be a problem. Should he need to come up with some fast money, he may be forced to sell stocks at a loss.

Stashing free cash is always a good idea, either as a precaution against that rainy day or if you're on the sidelines waiting to move back into equities. But don't shortchange yourself. The general rule of thumb is to store away at least three to six months of living expenses. That amounts to $9,000 to $18,000 for the average American household, based on 1998 statistics. The reliability of your paycheck and those plans for that trip around the world next year should be factored in, too. You may need to keep even more cash on hand if you have major expenses coming up, such as a downpayment on a house or a child's tuition bill.

But where to stockpile your hoard? At first blush, now seems to be a good time for money-market funds, which invest in short-term debt, such as commercial paper and Treasury bills. The Federal Reserve's year-long mission to slow the U.S. economy has pushed money-market fund yields to heights not seen in nearly a decade. The average yield on a taxable money fund is now 5.93%, the highest since April, 1991, and way above their recent low of 2.62% in 1993.

LESS VOLATILE. Still, unless you're certain that you'll need cash in six months or less, shifting your cash into the money markets isn't necessarily your best bet. Instead, consider short- and ultrashort-term bond funds, both of which historically have paid higher yields than money-market funds. "If you can get a little more, why not?" says Robert MacIntosh, portfolio manager and chief economist for Eaton Vance Funds in Boston.

Over the past three years ended May 31, ultrashort bond funds turned in an average annual return of 5.26%, beating money funds' average of 4.94%, says Morningstar. Many funds have eked out even better returns, such as Eaton Vance Prime Rate Reserves, which boasted an average three-year return of 6.59%. Right now, some ultrashort bond funds are yielding close to 8%, and short-term, investment-grade funds are yielding around 7.5%.

Short-term bond funds are a little riskier than ultrashort funds: They generally buy bonds that mature in three to five years, while ultrashort-term funds invest in securities with a maturity of one year or less. But because of their limited duration, both short and ultrashort bond offerings are considered less volatile than long-term bond funds, whose value can plunge when interest rates rise.

Like money-market funds, many short and ultrashort bond funds now have the flexibility of check-writing privileges. But they tend to carry higher management fees than money funds, whose average expense ratio is about half a percentage point. By contrast, some ultrashort bond funds have expenses of up to 1.7% of assets, although there are those with expenses of as little as 21 basis points. Some bond funds come with a 3% sales charge, too, while money-market funds don't charge such commissions.

Those fees will eat into returns, but John Hixson, a financial planner in Lake Charles, La., says it's worth paying for professional money managers who can ferret out high yields and preserve asset values. Indeed, not all ultrashort funds are alike. Most funds focus on high-grade government and corporate bonds, though a handful dabble in riskier issues to jack up yields. It's important to look for long-term track records and read a fund's prospectus carefully to see what types of bonds it buys.

The $2.5 billion Strong Advantage Fund, for example, has sometimes tended to feast on junk debt, but it has a stellar record of managing the added risk. Back in 1994, one of the worst years on record for bond performance, Strong Advantage was up 3.56%. The fund's 30-day average yield is a healthy 7.23%, far outpacing the best money-market yield so far. Lately, fund co-manager Thomas Sontag has trimmed more risky securities to about 10% of assets and loaded up on floating-rate debt. "There's plenty of opportunity to get yield on the books without having to go down the credit spectrum," Sontag says. "Yield is not a problem."

Strong's expense ratio is a fairly modest 0.8%. If you're looking for a short-term bond fund with even lower expenses, you may want to consider Vanguard Group's short funds. Its $1.1 billion Short-Term Bond Index Fund, for instance, sports a 0.2% expense ratio. It tracks the Lehman Brothers 1-5 Year Government/Corporate Bond Index and invests in U.S. government bonds and high-quality corporate bonds. Its three-year return was 5.39%.

FLOATING RATES. Vanguard Group's $6.7 billion Short-Term Corporate Fund, meanwhile, dabbles in riskier BBB-rated debt, in some cases up to 30% of assets. That mix put the fund in the top quintile in 1999, as well as for the past three, five, and 10 years.

For investors in a high tax bracket, the $968 million USAA Investment Management's tax-exempt Short-Term Fund is a good option. Manager Clifford Gladson has run this fund since 1994, steering toward some of the lowest volatility measures for its category by acquiring low-risk municipal bonds around the country. He focuses on booming economies, such as New York state, and high-performing sectors, such as health care. The fund's three-year annualized return is 5.09%.

Financial Planner Ben Utley of Utley & Associates in Eugene, Ore., has moved some of his clients recently into floating-rate funds, another ultrashort option. He's particularly keen on the $195 million Eaton Vance Advisors Senior Floating Rate Fund, which invests in senior secured bank loans. In some cases, Utley has moved half to all of a client's cash allocation, which is usually about 10% of assets, into the new fund. He's also using the fund to ease one of his clients, who is the recipient of a $2 million inheritance, into the stock market. The client has put 10% of his money into a "sweep" money-market fund at Charles Schwab; 65% in the Eaton Vance fund; and 25% in SEI's S&P 500 Index Fund. Utley will bump up the client's equity investments by about $500,000 each year for three years until his client is fully invested.

"He saw the Nasdaq take this plunge and decided to wait a few years to be fully invested," Utley explains. If you need to build up your cash cushion or are setting money aside for specific purposes, short and ultrashort bond funds are certainly worth a longer look.

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