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How Short-Term Bond Funds Went Wrong (Again)

Echoes of the financial crisis reverberated across short-term and ultrashort bond funds in March 2020.

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Back in 2008, several funds in the short-term bond and ultrashort bond Morningstar Categories that had invested in securitized bonds backed by subprime mortgage loans got caught in a liquidity trap, as falling prices led to heavy redemptions and forced selling. The destruction of value was severe enough to put some funds, such as ultrashort bond heavyweight Schwab YieldPlus, out of business. It was a devastating outcome for investors who believed these vehicles were just a little bit riskier than cash.

After the financial crisis, short-term bond funds started to look a lot more compelling because of the Federal Reserve's prolonged zero interest-rate policy and fears that all-time low yields increased the perception that a painful bear market for bonds was just around the corner. While the memory of high-profile blowups may have deterred some investors from ultrashort bond funds initially, many came around once the Fed's rate hikes (beginning in December 2015) made these funds' yields more enticing. Relatively safe money market funds, meanwhile, were increasingly restricted from taking advantage of some of the higher-yielding issues available to ultrashort bond funds.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.