The Dangers Of Ultra-short Bond Funds

Ulli Uncategorized Contact

It’s pretty much a given that, every time our Trend Tracking Indexes (TTIs) have us out of the market and in money funds, somebody (a client or a reader) will ask if we can’t use the idle cash to buy some ultra-short bond funds to enhance returns.

There are reasons why I don’t get involved in those types of securities, some of which have been addressed in “Broken Bonds,” by MarketWatch:

When it comes to investing, there are times when boring is good, when the idea is to find a safe haven in a fund that does a simple job, easily and without flash, the kind of mutual funds you can hold without fear of what happens the next time you look at your statement.

For more than a year now, however, investors who have parked money in ultra-short duration bond funds have come away feeling like their investment vehicle has been vandalized while their cash was parked.

Over the past 12 months, the average ultra-short bond fund is off 1.66%, according to fund-tracker Lipper Inc. So far this year the situation is uglier, with the average fund in the category losing around 2.2% of its value.

For some of these funds, however, damages have been far worse. SSgA Yield Plus is down 30% in 12 months through May 8. Meanwhile, Schwab YieldPlus has lost almost 29%, and Fidelity Ultra-Short Bond has taken a 12.9% haircut.

For an ultra-short bond fund, that’s as ugly as it gets. For investors, it’s important to know how this happened and how a fund that is supposedly so safe can turn out to be so dangerous.

The cause of the problems should be obvious even to casual investors, namely the subprime credit-crisis; the troubled ultra-short funds typically hold a big slug of asset-backed securities tied to the performance of the housing market.

When the housing market went into the tank, it took housing securities with it. Many institutional investors who had bought similar securities — including some hedge funds — had to either sell these investments or shut down; they opted for the former and flooded the market with notes, dropping prices even further.

Investors today clearly recognize the danger in subprime asset-backed securities, but before all of the trouble started, these securities were considered safe enough to fit into the investment profile of a risk-averse fund like an ultra-short. Money managers looking to squeeze some extra returns from the market went down the slippery slope towards subprime debt supported by the ratings agencies such as Standard & Poor’s and Moody’s Investors Service, which had test-driven the securities and given them appropriate ratings. Managers thought they were within their designated safety parameters.

So much for perceived safety! I have found over the past 25 years that when our Trend Tracking Indexes, especially the domestic one, are below their long-term trend lines, we are without fail living in times of great uncertainty.

The markets are in bear territory heading further south or aimlessly meandering and going nowhere. During that period, it’s important not to have any market risk with your idle cash. Yes, it’s tempting to try to spruce up the yield a little bit, but it simply is not worth the extra risk as many have found out over the past year.

After the bursting of the tech bubble in 2000, or now in the midst of the Subprime/credit/housing crisis, the theme remains the same: Safety of your portfolio comes first, and investments are made with clearly defined entry and exit points to control the risk.

If you want to be totally out of the market, safely on the sidelines and isolated from any risk, ultra-short bonds are not the tool to use; U.S. Treasury only funds are.

No Load Fund/ETF Tracker updated through 5/15/2008

Ulli Uncategorized Contact

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Upside momentum pushed our domestic Trend Tracking Index out of the neutral zone and into buy mode effective Thursday, May 15, as announced.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now moved to +2.63% above its long-term trend line (red):



The international index improved but remains -0.78% below its own trend line, keeping us still on the sidelines.



For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

Domestic Buy Signal Generated

Ulli Uncategorized Contact

Today’s tame CPI report (+0.20% vs. an expected +0.30%) provided enough ammunition for the bulls to drive the major indexes higher. As details about the CPI report became public, namely that gasoline prices fell 1.8% in April, the trading floor erupted with laughter. That goes to show that traders have a sense of humor just like you need to have if you hear numbers like that.

Although the rally faded during the afternoon session (see MarketWatch chart above), the gains were enough to keep our domestic Trend Tracking Index (TTI) above the neutral range with a reading of +1.72%, unchanged from yesterday’s close.

This now constitutes a new Buy signal for diversified domestic equity funds effective tomorrow, Thursday. While we can never be sure if this trend will continue, I will now ease into the market with about 1/3 of portfolio value. Most important after the purchase are my stop loss points.

I will use a 7% trailing stop loss on all positions on a day-end closing price only. Therefore, a sell signal will be generated, if my holdings violate the stop loss points or if the domestic TTI drops below the lower range of the neutral zone, which is a point -1.50% below its long-term trend line, whichever occurs first.

I will post further updates as necessary.

Staying Above The Neutral Zone

Ulli Uncategorized Contact

Despite a pullback in the market on Tuesday, the domestic Trend Tracking Index (TTI) managed to stay above the upper range of the neutral zone. Its position is now +1.72% above its long-term trend line. If the TTI can remain above the +1.50% level for another trading session, a domestic Buy will be validated, and we will move back into the domestic arena with about 1/3 of our portfolios.

Right now, it appears that the path of least resistance is to the upside, as the past few weeks have shown. Barring any unexpected negative news with the announcement of Wednesday’s CPI, we may find ourselves back in domestic equities in a couple of days.

Upside Breakout—Again

Ulli Uncategorized Contact

Here we go again. Yesterday’s rally erased pretty much all of Friday’s losses and pushed our domestic Trend Tracking Index (TTI) back out of the neutral zone.

The domestic TTI has now moved to +1.83% above its long-term trend line, slightly above the upper range of the neutral zone (defined as a level of +1.50% above its trend line).

Again, if this level holds for a couple of trading days, it will constitute a domestic Buy, and we will move back into that market.

Internationally, nothing changed as the international TTI still remains -2.29% below its long-term trend line.

Types Of Risks

Ulli Uncategorized Contact

MarketWatch featured a story called “Point of no return,” which questions whether risk taking is worth the emotional cost for many investors.

Eight different types of risks are examined with the premise that there more of these are faced in a portfolio, the more diversified it is:

Let’s look at the types of risks mentioned:

1.Market risk is the big bugaboo, the chance that a downturn chews up your money.

2.Purchasing power risk, or “inflation risk,” is widely considered to be the “risk of avoiding risk” — the opposite end of the spectrum from market risk. It’s the possibility that you are too conservative and your money can’t grow fast enough to keep pace with inflation.

3. Interest-rate risk is a key factor in the current changing rate environment, where income may change drastically when a bond or CD matures and you need to reinvest the money. Goosing returns using higher-yielding, longer-term securities creates the potential to get stuck losing ground to inflation if the rate trend changes again.

4. Shortfall risk is about you, personally, more than it is the market, but it’s the chance that you won’t have enough money to make your goals. You can face shortfall risk by being either too conservative or too aggressive. The best way to address this risk is to save more.

5. Timing risk is another another highly personal factor, hinging on your personal time horizon. While experts agree that the chance that stocks will make money over the next two decades is high, the prospects for the next two years are murky, and if you need your money in two years, you should have concerns about your timing.

6. Liquidity risk has been the underlying issue in the mortgage and credit crunch, and it affects everything from junk bonds to foreign stocks. When the flow of money in credit markets changes for any extended period of time, holdings in those credit arenas tend to suffer.

7. Political risk is the prospect that government decisions will impact the value of your investments. In the current political environment, investors should worry about how the change at the White House may lead to new tax policies, which could trickle down directly into the pocketbook for investors. Tax-rule changes could make certain types of investments popular, and make others unattractive, and there’s always the potential to be caught somewhere in the middle.

8. Societal risk is ultra-big picture, looking at world events. This is what might happen in the event of terrorist attacks, war or catastrophe.

The theme of the story is is that “diversifying across the spectrum of risks — particularly pursuing investments that face different conditions so that their success or failure is not all tied to the same market characteristics — is widely considered the best way to build a portfolio that can be depended on in all circumstances.”

Sure diversification is an important part of any portfolio—up to a point. As recent market history has shown (as well as the last bear market), we are living in an era of instant communication and economic intertwinement where as a result a receding tide affects all ships. I have commented on that a year ago in “Where is the safe Haven,” as all asset classes took severe beatings.

Yes, diversification is important, but from my viewpoint it is not nearly as critical as having a defined entry and exit strategy designed to reduce volatility and protect a portfolio from severe downturns. Remember, most diversification attempts are based on a bullish (buy & hold) scenario, which can have severe consequences if the markets head the other way.