What Is an Ultra-Short Bond Fund?

Jim B.

An ultra-short bond fund is a collective investment vehicle that concentrates its investments on bonds that have a relatively short time to maturity. Generally, the bonds are set to expire in less than a year, meaning that they will usually expire too quickly to be affected by any rise in interest rates in the bond market. As a result, an ultra-short bond fund can be beneficial to those investors who want to park their money and get better returns than would be achieved by money market funds or certificates of deposit. These funds carry some risk that bond defaults can cut into the capital invested.

Certificate of deposit accounts -- commonly called CDs -- require letting a bank hold a certain amount of money over a period of months or years.
Certificate of deposit accounts -- commonly called CDs -- require letting a bank hold a certain amount of money over a period of months or years.

Bonds are issued by institutions to raise money from investors, who receive fixed income from the bonds in the form of interest payments determined by a bond's coupon rate. In addition, bondholders also generally receive the principal paid for the bond when the bond reaches its maturity. Investors choose bond funds as a way of gaining portfolio diversity through a single investment. One particular bond fund focused on bonds of short maturities is known as an ultra-short bond fund.

In general, the bonds included in an ultra-short bond fund have maturities of less than a year. It is important to understand that different funds may have looser guidelines on the bonds in which they are allowed to invest. Investors can study a bond's prospectus to see what the strategy of a specific fund might be. When the net asset value of the bonds in a bond fund rises, investors receive the benefit in the form of capital gains.

What makes an ultra-short bond fund valuable to investors is that it is generally impervious to the effects of rising interest rates. Bonds held by investors lose value when interest rates in the bond market rise. This is because newly-issued bonds can offer higher rates to investors than the ones attached to bonds purchased in the past when interest rates were lower. If the maturity is short, it gives less time for interest rates to rise, thereby increasing the chance that a bond will hold its original value.

As is the case with most investment opportunities, certain risks are attached to an ultra-short bond fund. Corporations which issue bonds could default on their obligations, which means that principal might not be returned to investors. When this happens, investors in an ultra-short fund might see negative returns. This makes ultra-short bonds riskier than safe counterparts like certificates of deposit or money market funds, which promise modest but also contain hardly any risk.

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