A Good Reason to Keep It Simple In Bond Investments

 The Wsj has a good article reviewing issues related to some bond funds labeled as ultra short term which carry very high credit risk akin to a long term bond in their quest for higher yields.

Probably the most notable in this category is the Schwab Yield Plus Fund.

The Schwab yield plus fund is pretty notorious among the knowledgeable. It was promoted by Schwab as a cash alternative prior to fall 2008 and was adopted as such by both individual investors and advisors as well.

Much to the dismay of all involved the market dislocations of 2008 showed where those high yields came from: increased credit risk even though the duration of the funds holdings was kept short. Essentially the fund held longer term bonds of corporations of low credit quality. Through the use of interest rate swaps they reduced the sensitivity of the holdings to changes of interest rates making the duration (sensitivity of a bond to changes in interst rates) short akin to a short term bond. But since the underlying bonds were of low credit quality and long maturity they reacted to the credit crisis based on the maturity. This study explains this in more depth,  it is from a firm that advises the litigators in a current. At least class action legal action  .

Here's the performance from the Schwab website

Cumulative Growth of a $10,000 Investment (pre-tax)

This graph represents the growth of a hypothetical investment of $10,000. It assumes reinvestment of dividends and capital gains, and does not reflect sales loads, redemption fees or the effects of taxes on any capital gains and/or distributions.

Here's how it is described on the website

Investment Goal and Strategy

Seeks to provide a higher yield, with a higher related risk, than a money market fund, and relatively less risk than a longer-term bond fund. YieldPlus seeks to maintain an average portfolio duration of 1 year or less. This fund is not a money fund and its share price will continue to fluctuate.

no mention of the maturity credit risk issue

Morningstar waited till august 2008 to tell investors to dump the fund as reported by Business Week at the time.

my bolds and comments in blue

About Those Alleged Short-Term Funds...

Some Go Long on Bonds, Risk—Study

By JANE J. KIM

Two years after surprise losses in auction-rate securities pounded mutual funds, there is new evidence to suggest some funds may be mislabeling what they hold in their portfolios.
According to a study set to be released Thursday, some short- and ultra-short-term bond funds, which purport to invest in fixed-income securities with short maturities, hold long-term bonds as well, sharply increasing risks.....

The study, by Securities Litigation & Consulting Group, a Fairfax, Va., consulting firm that provides expert witnesses to regulators, law firms, banks and brokerages, examined bond funds' holdings in early 2008. The research showed that the weighted average maturity of ultra-short funds washttp://18 years—with 50% of the 43 funds having average maturities greater than 20 years—while the weighted average maturity of short-term bond funds was 12 years.
The credit risk in their long-term bond holdings caused many of the bond funds to post steep losses during the financial crisis later that year, according to the study. Funds that reported the steepest losses in 2008 generally owned securities with the longest average maturities unless the long-term holdings were mostly government securities.

The key problem is that the "effective duration" statistics does not reflect the credit risk in these funds which is the same as in many longer term funds.

And investors apparently can't rely on Morningstar to reflect this risk according to the article:

The issue at the center of the new paper is how bond funds report their "effective duration," a statistical measure of their sensitivity to changes in interest rates. Because many of these funds held floating-rate bonds or used derivatives to convert their fixed coupons to floating-rate coupons, they were able to report effective durations as short as three months—even though their 20- to 30-year average maturities would imply durations of 10 or 15 years, according to the study.Morningstar Inc,a research firm also uses the statistic to categorize funds 

"You've got these long-term bond portfolios that the industry and Morningstar are telling investors are short-term or ultra-short bond funds," said Mr. McCann. "But it's not true for a large portion of these funds. Many, in fact, have the credit risks of long-term bonds."

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At one extreme, according to the paper, Charles Schwab Corp.'s YieldPlus Fund, classified as an ultra-short bond fund, had a weighted average maturity between 25 and 30 years. .".....

Although many of the funds have pared back their average maturities since 2008, some funds still hold long average maturities. At the end of 2009, for example, the AMF Ultra Short and Ultra Short Mortgage Funds, which hold mainly mortgage-backed securities, had average maturities of around 20 to 25 years, according to Mr. McCann.

The solution for investors to this dilemma is to choose etfs for their bond investments. These funds clearly stick to their label in terms of credit quality and their average effective duration deviates minimally from their average maturity. For example take these vanguard etfs:

short term investment grade corporate

for the intermediate fund the duration is 6.2 years and the maturity 7.2 years  no holdings rated below Baa

for the short term fund the duration number is 2.8 yrs the maturity 3.1 yrs