Best of Both Fund Worlds

USAA's tax-exempt short-term bond funds offer the safety of money-market funds along with the higher yields of bond funds

By Amey Stone

March has dished out a major incident of international terrorism, increased worries about the strength of the U.S. economic recovery, heightened stock-market volatility, and interest rates that are lower than ever. That's a recipe for even worse returns on the safest investments –- just at a point when mutual-fund investors may be craving a little extra security.

As of Mar. 17, the average money-market fund was yielding just 0.51% -- a record low, according to industry newsletter Money Fund Report. That's down from 0.75% a year earlier. Bond funds offer higher yields but come with interest rate risk. Many economists believe rates have bottomed (although they've been saying that for about two years now) and are likely to rise by yearend. Since bond prices move inversely with interest rates, investors who buy a bond fund now could be setting themselves up for losses when rates climb.

There is, however, an alternative to money funds that offers a boost in current income with hardly any interest rate risk, says Clifford Gladson, who heads fixed-income investing at USAA Investment Management. USAA's funds are marketed to military personnel but are open to anyone. Its highly regarded fixed-income division has 14 bond funds and was just awarded fund tracker Lipper's Best Bond Group award on Mar. 16.


  Gladson's choice for yield-hungry, risk-averse fund investors is USAA's Tax-Exempt Short-Term Bond Fund (USSTX ). The fund now yields 1.47%. That's almost three times that of the average money fund. Even better, when you consider its tax-exempt status, that's equivalent to a yield of 1.93% for investors in the 25% tax bracket -- or a 2.23% yield for those in the 35% bracket.

What about the interest rate risk? Gladson and his co-portfolio manager Regina Shafer pack the portfolio with a diverse crop of about 200 short-term municipal bonds (the shorter the time to maturity, the less vulnerable the bond is to falling in price as interest rates rise). The fund's average maturity is 2.2 years, shorter than the average short-term bond fund, according to Morningstar.

Another way the portfolio managers dampen rate risk is by keeping about one-third of the portfolio in variable-rate demand notes (a kind of municipal security, usually backed by a large bank, that can be sold back to the issuer at full face value on short notice). Because of the way these securities are structured, they don't fall in value even if rates go up. So in a rising-rate environment, investors get the benefit of a higher coupon without the risk of a drop in market value. Those notes currently yield an average 0.92%.


  While the fund's price could rise or fall (unlike money funds which are designed not to fluctuate in price at all), the day-to-day fluctuations should be modest. In fact, short-term rates would have to rise by 1.5 percentage points -– an unlikely jump anytime soon -- for returns of the short-term tax-exempt fund to break even with a money fund, says Gladson.

Investors with a three- to five-year time horizon could probably benefit from taking a little more risk and putting their money in the USAA Tax-Exempt Intermediate Term Fund (USATX ), which is now yielding 2.72%, says Gladson. Rather than trying to market-time changes in interest rates, he thinks investors should pick bond funds based on time horizon. If you could need the money in two years or less, go with short-term. Need it in three to five years? Pick an intermediate-term bond fund.

Gladson knows an intermediate-term fund is "a tougher sell" in an environment in which rates are at record lows and conservative investors likely feel safest in money funds. But he'll be happy if he can win over a few converts from low-yielding, taxable money-market funds into his short-term tax-exempt fund.


  Many fixed-income investors have now spent two years in money funds waiting out a potential rise in rates. While they didn't lose money, the "opportunity cost" of missing out on higher yields has been substantial, says Gladson. "Rates could stay low for a number of years."

Investors shouldn't move all their money out of money funds, says Connie Bugbee, editor of Money Fund Report. But a tax-exempt short-term fund does make sense for some of your savings, especially if you're in a high tax bracket.

These funds aren't completely risk-free. "No one can say you can't lose money in them," she says. But rates would have to rise awfully far very quickly to lose money in USAA Tax-Exempt Short-Term Bond. That's an attractive lure for anyone tired of waiting out the impending rate rise in a money fund earning 0.5% a year.

Stone is a senior writer at BusinessWeek Online and covers the markets as a Street Wise columnist

Edited by Beth Belton

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