NEW YORK, Dec 11 (Reuters) - Stranded in the land of near-zero interest-rate policy, it's a wonder any ultra-short bond fund can survive, let alone be among the seven to earn a five-star Morningstar rating among 80 ultra-short bond funds.
But the Ridgeworth U.S. Government Securities Ultra-Short Bond Fund fund has managed to thrive, passing its 10-year anniversary this year and beating the average fund during that time despite rock-bottom rates.
The fund has managed to outperform the indexes in part because of its eye for mortgage-backed securities, which carry higher yields than short-term government bonds with minimal added risk.
Formed in April 2002, the Ridgeworth fund has enjoyed average annual returns of 3.01 percent and 3.03 percent over five and 10 years, respectively, surpassing average returns on the Barclays Capital 3-6 Month Treasury Bill Index of 0.99 percent and 1.98 percent over the same periods.
The biggest challenge for a short-term bond fund when the Federal Reserve is trying to keep short-term rates near zero is to produce enough of a return to persuade people to keep their short-term cash in a fund instead of the proverbial mattress.
"We buy mortgage securities that offer a yield advantage over other short-term Treasury and government-guaranteed obligations, but which don't substantially add duration," said Chad Stephens, managing director at Stable River Capital Management in Atlanta and manager of the Ridgeworth U.S. Government Securities Ultra-Short Bond Fund.
"That gives the investor the advantage of exposure that is slightly longer than money market securities, while maintaining next-day liquidity," he said.
Stable River Capital Management LLC has managed short- and medium-term bond funds for more than 20 years and is one of several sub-advisers to Ridgeworth Investments.
The Ridgeworth Ultra-Short Bond Fund ranked second out of 38 funds in the ultra-short obligations Lipper category over a 10-year time span and second out of 53 such funds in a five-year time-frame. It earned a 1.66 percent return year-to-date, as of Sept. 30, 2012, versus 0.10 percent on the Barclays Capital 3-6 Month Treasury Bill Index.
Some other short maturity funds take on greater risk, including high yield, foreign debt, or credit default swaps (CDS), but the Ridgeworth Ultra Short fund invests only in securities that are explicitly or implicitly guaranteed by the U.S. government, Stephens said.
Short-term rates have been hovering near zero ever since the Federal Reserve introduced its near-zero interest-rate policy in December 2008. With safety in hot demand, investors have been willing to put money into short-term bond and money market funds despite their low yields.
As of Dec. 5, total assets in money market mutual funds stood at $2.644 trillion, according to the Investment Company Institute, about the same amount as in 2006-2007, when money market funds yielded 4.5 percent.
Stephens has bought adjustable rate mortgages in the past, but his fund is as light as it has ever been on ARMs because their high prices leave little margin for error. A slight move in conditional prepayment rates could hit the portfolio hard.
"Just a one-point change in the conditional prepayment rate (CPR) translates into as much as 10 basis points in yield," Stephens said. "If your pre-payment assumptions are wrong, a bond you thought you were buying at an attractive yield could actually deliver a negative yield by pre-paying faster than anticipated."
Instead, the Ridgeworth fund is buying more floating rate collateralized mortgage obligations, a security based on a pool of mortgages. Stephens said floating-rate agency CMOs are less sensitive to changes in pre-payment speeds.
CMOs created after the financial crisis, when credit standards tightened, are attractive to investors who want to stay defensive by staying in a government-guaranteed investment with slightly better yields than a Treasury security, he said.
Stephens said the "fiscal cliff," automatic tax hikes and spending cuts set to take effect after Dec. 31, does not loom large in terms of steering his portfolio. He expects some partial solutions to these issues by year end, with other questions left to be resolved farther down the road.
"The 'fiscal cliff' is almost like this decade's Y2K," Stephens said, referring to the scare that computer systems would cease to function on Dec. 31, 1999, which did not materialize.
What could drive some money into ultra-short bond funds is the expiration of the Transaction Account Guarantee program, now set for Dec. 31, Stephens said.
The TAG program, conceived to help provide liquidity to the banking system after the financial crisis, provides full deposit insurance coverage for non-interest bearing transaction accounts of banks and credit union customers. Balances in these accounts total nearly $1.5 trillion, according to the latest data from the Federal Deposit Insurance corporation.
If insurance on these now-guaranteed accounts is cut to the usual $250,000, customers who park funds in those accounts might try to get a modest return in a short-term fund, Stephens said.
It is unknown, however, if the unlimited FDIC insurance on those accounts will actually expire after Dec. 31. A bill has been introduced to extend the program, but it has not been passed by either House of Congress.
If money leaves the guaranteed transaction accounts and moves into short-term Treasuries, that could further depress short-term Treasury rates, Stephens said. Investors frustrated with even-lower rates could choose an ultra-short bond fund "like ours that is willing to take a little bit of an extension risk to get to a better yield," he said.