Not All Short-Term Bond Funds Look Alike

Short term bond managers have had the test of a lifetime this summer as wildly gyrating bond and credit markets have repriced their holdings considerably. Funds with nearly identical fund profiles and types of holdings may have considerably different returns. Some funds have hedged their losses with derivatives, while some funds have maintained a clean portfolio without the exposure to subprime mortgages-based securities. One institutional fund, The State Street Limited Duration Bond Fund, which managed $1.4 billion for institutional clients, lost about 37 percent of its value during the first three weeks of August (see article). Investors in short-term bonds funds have averaged around 3% returns for 2007. Here are some sample returns with the main core holdings in each fund:

Vanguard Short-Term Bond Index (VBISX) 3.88% YTD return, 47% Treasuries and only 7% GNMA securities

Fidelity Short-Term Bond (FSHBX) 0.78% YTD return, 37% Treasuries

Fidelity Ultra-Short Bond Fund (FUSFX) -1.81% YTD return, 41% Asset-backed securities, 33% GNMA securities

Fidelity Government Income Fund (FGOVX) 3.59% YTD return, 39% GNMA securities, 31% Treasury Notes/Bonds

BlackRock Low Duration Bond (BLDAX) 3.47% YTD return, 57% GNMA securities

Metropolitan West Low Duration Bond (MWLDX) 2.25% YTD return, 24% GNMA securities

Vanguard Inflation-Protected Securities (VIPSX) 4.84% YTD return, 99% Treasury Notes/Bonds

Harbor Real Return (HARRX) 3.58% YTD return, 90% Treasury Notes/Bonds

BlackRock Government Income (CCGAX) -2.10% YTD return, 95% GNMA securities

Vanguard GNMA (VFIIX) 2.68% YTD return, 100% GNMA securities

An investor cannot blame exposure to GNMA Securities if their bond fund is outperforming as Vanguard's 2.68% return in their GNMA fund indicates. And despite inflation being somewhat tame, the inflation-indexed funds (Harbor Real Return and Vanguard Inflation-Protected Securities) both are lodging impressive returns for 2007. So how can an investor avoid the kind of fund debacle at State Street that can cause losses to principal?

(1) Carefully review the portfolio holdings - while GNMA securities may be OK they are not as stable as U.S. Treasuries

(2) The shorter the average duration of the holdings in a fund the less volatile the fund will be

(3) Higher yields typically come with higher volatility. Don't just buy the short-term bond fund with the highest yield without reviewing the portfolio holdings.

(4) Buy a Morningstar Fund Rating Report. Let the experts (and not your broker) tell you about the fund you are considering purchasing.

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