Fixed Income

Ultra Short-Term Bond: A Flexible Alternative for Short-Dated Investments

September 25, 2018
Looking back at the creation of the Ultra Short-Term Bond Fund as it celebrates its five-year anniversary.

Key Points

  • The T. Rowe Price Ultra Short-Term Bond Fund was created five years ago to address investor demand for high-quality, short-dated investment alternatives that sought to provide flexibility and stability while generating income.
  • Our approach takes advantage of T. Rowe Price’s robust credit research capabilities to utilize our more flexible opportunity set in an effort to increase income.
  • Managing risk remains an important goal for investors seeking yield in a rising rate environment.

Q. What need was addressed through the creation of the Ultra Short-Term Bond Fund five years ago?

Looking back to the fund’s 2012 inception, there were a few catalysts for launching the Ultra Short-Term Bond Fund. Among them was the need to provide investors a better return in the low interest rate environment, which we expected to continue for quite some time. We believed that investing in higher-yielding investment-grade securities that are longer in maturity (up to three years) than money market funds are restricted to could provide better outcomes. Money market funds are restricted to maturities that cannot exceed 60 days and are largely limited to the two highest credit rating tiers. The T. Rowe Price Ultra Short-Term Bond Fund can invest in the entire investment-grade universe with maturities of up to three years, including short-term investment-grade and government securities, asset-backed securities, and bank obligations.

Another catalyst for the creation of the fund was that anticipated money market reform would curtail investment opportunities available to money fund investors. Institutional investors would be forced into prime money funds with floating net asset value (NAV) money market fund investments that could also impose restrictions on their most liquid investment or government money funds with very low returns. Institutional investors largely chose to move their assets from prime money funds into government money market funds. Retail investors would have a similar choice: a government money fund offering very low returns but a stable $1.00 NAV, or a prime money fund that might impose fees or restrictions on withdrawals.

Last, over the long term, we believed that an ultra short-term bond fund would provide traditional money market investors with another investment option for those investors willing to accept additional risk in return for the potential of increased yield. That brings us to today’s climate.

MONEY MARKET REFORMS

The Securities and Exchange Commission’s (SEC) money fund reforms, enacted in October 2016, are intended to prevent a run on money market funds like the one that occurred during the 2008 financial crisis. The SEC categorizes money funds as government, retail, and institutional. Distinctions also exist between government and nongovernment funds. Under the new rules, institutional nongovernment money funds must allow their net asset value (NAV) to fluctuate daily above and below $1.00 to reflect current market prices of underlying holdings. Institutional investors are not allowed to invest in nongovernment money funds designed for individual investors. Money funds sold to individual investors can continue to be managed to keep their NAV at $1.00. The rules require all nongovernment money market funds to have the ability to temporarily prevent investors from making withdrawals or to impose liquidity fees for investors who redeem shares during times of stress in the money market. Government money funds are not required to have the ability to impose liquidity fees or restrict redemptions.

Q. What specific features or strategies did you highlight as objectives for the Ultra Short-Term Bond Fund?

We designed the Ultra Short-Term Bond Fund as an investment alternative for money market investors; however, the Ultra Short-Term Bond Fund is not a money market fund—it’s a bond fund that prioritizes liquidity and price stability, while maintaining a low duration profile.

Liquidity. In the past, money market investors had the ability to make withdrawals without restrictions. This feature has been limited somewhat following money fund reforms. Because this was an important feature to investors, the Ultra Short-Term Bond Fund maintains a large buffer of liquid assets to accommodate redemptions in an effort to provide similar access to unrestricted withdrawals.

Principal Stability. Money fund investors are also accustomed to a stable $1.00 share NAV. This changed with money market reform, reducing options that could guarantee a stable $1 per share NAV. We felt investors would seek alternatives that focused on minimizing price fluctuations. While the NAV for Ultra Short-Term Bond Fund is not fixed, historically, it has been relatively stable (Figure 1).

Low Duration. The Ultra Short-Term Bond Fund also features a low duration profile, and thereby has reduced sensitivity to interest rate changes. We wanted to take our experience in money market fund investing and apply it to ultra short-term bond, by extending maturities to one- to three- years in an effort to provide an incremental yield advantage.

Q. Describe your investment strategy. What are you doing to enhance principal stability?

The Ultra Short-Term Bond Fund was designed to provide unrestricted redemptions, increased income, and reduce price fluctuations. Achieving all three of those features creates an attractive product for low-duration investors.

To achieve ample liquidity, we routinely maintain a position in U.S. Treasury bills, strictly to meet redemptions. This comes out of the lessons learned in 2008. If liquidity evaporates in the market and demand goes away, you don’t want to be a forced seller at distressed prices simply to fund redemptions. A liquidity position in Treasuries becomes invaluable in that environment.

To enhance income, we can buy securities that have slightly longer maturities that come with additional spread. We can increase yields in sync with the three-month Libor rate, but because we may own securities that have a three-year final maturity, we get the incremental spread associated with a three-year bond.

By building a portfolio of bonds maturing at different dates, we seek to increase liquidity, reduce interest rate risk, and diversify credit risk. Our securitized positions pay down principal and interest each month, providing a source of cash flows as they mature that allow us to either increase our liquidity buffer or reinvest back into the market at higher rates.

Q. What aspects of your strategy do you feel contributed to the early success of the Ultra Short-Term Bond Fund?

The benefit of an ultra short-term bond fund is that it can provide incrementally better return than money funds by taking on short-dated credit risk. While money funds are constrained to a very short maturity horizon, typically one month to three months, the Ultra Short-Term Bond Fund typically invests in securities that mature in one year to three years and occasionally even out to five years. It can also include floating rate debt. Similarly, the fund can invest in the full investment-grade spectrum. While money funds are constrained to the two highest ratings categories, the Ultra Short-Term Bond Fund can invest in securities rated BBB or higher.

Another advantage of the Ultra Short-Term Bond Fund is that the fund can invest in a more diverse set of security types. Not only are we investing in corporate bonds and government bonds, but we have fairly robust positions in securitized products, including asset-backed securities, mortgage-backed securities, and commercial mortgage-backed securities.

By building a portfolio of bonds maturing at different dates, we seek to increase liquidity, reduce interest rate risk, and diversify credit risk.

Q. How have you used the Ultra Short-Term Bond Fund’s more flexible opportunity set?

Our extensive use of floating rate securities as we transitioned to a rising rate environment benefited performance. We incepted the fund in the midst of Federal Reserve quantitative easing, which lasted for the first two to three years of the fund’s existence. At that time, the strategy invested in longer-dated credit to provide yield pickup and some principal returns as all rates were continuing to fall and spreads narrowed. That situation changed by about the third quarter of 2016 with the prospect that the Fed would begin to unwind its balance sheet, which it has since begun to do.

The shift to floating rate securities is all about what I see as a repricing of interest rates following the financial crisis and the last 10 years of central bank-induced rate suppression. I believe we are at the cusp of a period of time where we will see rates move back to more normal levels, where short-term rates in the 3% to 4% range are not unusual at all.

I don’t think investors have fully grasped the implications, especially in fixed income portfolios, of a very slow and steady progression of rate increases by the Federal Reserve through 2018 and 2019. That’s going to move base rates, such as the Libor rate and the overnight federal funds rate, to the 3% range for very short-dated investments.

Q. In this rising rate environment, where do you feel the Ultra Short-Term Bond Fund fits into a portfolio for retail investors and/or an advisor?

More importantly, in the current environment, as interest rates move higher—and I believe they will—we are in the final stages of a bond bull market or the early stages of a bond bear market. As a result, with its really low duration profile, the Ultra Short-Term Bond Fund provides the balanced attributes that fixed income investors may be looking for in this environment.

Q. Is the move to ultra short-term bond funds a temporary shift specific to this rising rate environment?

No, I see an ultra short-term bond fund as a core part of an investor’s portfolio. With a focus on trying to maintain price stability and investments in liquid assets, such as U.S. Treasury bills, an ultra short-term bond fund can complement many other investments.

Q. As the Fed continues to raise rates and other central banks look to do the same, do you see continued flows into the space?

Definitely. It’s my view that the Fed is going to raise rates at least three times throughout 2018 and probably at least another three times in 2019. That brings the overnight rate to somewhere in the range of 3%, which would affect interest rates at all maturities.

As a result of rising rates and perhaps a slightly risk-off sentiment that is beginning to creep into the equity as well as fixed income markets, we are seeing very good and continued flows into the product.

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Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of September 2018 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. The Ultra Short-Term Bond Fund is subject to credit risk, liquidity risk, call risk, and interest-rate risk. As interest rates rise, bond prices generally fall. In addition, mortgage-backed securities are subject to prepayment and extension risk. Bonds with lower credit ratings and floating rate loans involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. It is important to note that the fund involves more risk than a money market fund, which seeks to preserve the value of an investment. All charts and tables are shown for illustrative purposes only.

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