November 1, 2013

The Federal Reserve's plan to begin "tapering" its asset purchases has heightened concerns among fixed income investors about rising interest rates and consequent bond portfolio losses. Rising interest rates typically lead to higher bond yields and falling bond prices—which lower bond values.

Interest rates have faced upward pressure since the start of the summer when talk of potential Fed tapering made national headlines. With such pressure likely continuing, bond investors may be looking for shorter-term bond options less vulnerable to rising rates.

Bonds' sensitivity to interest rate changes is measured by a metric dubbed "duration," and lower-duration bonds and bond funds are relatively less at risk for potential losses in a rising interest rate environment.

T. Rowe Price offers a spectrum of lower-duration fixed income funds. Each of these funds offers a different strategy, yield, and set of risks. Options include: money market funds, the Ultra Short-Term Bond Fund, the Short-Term Bond Fund, the Tax-Free Short-Intermediate Fund, and the Floating Rate Fund.

Money Market

The firm offers several varieties of money market funds, including the Prime Reserve Fund and U.S. Treasury Money Fund. Each is distinct, but the overall goal is the same: principal preservation.

Money market funds are unique in that they are managed to maintain a stable share price of $1.00. So these funds are appropriate for investors who desire a stable investment. They are among the lowest-duration options but also provide the most limited opportunity for returns.

Money market funds generally invest in high-quality notes, bills, commercial paper, and certificates of deposit with maturities of typically less than one year. As such, they have the lowest interest rate risk and low credit risk relative to other funds.

"The combination of high quality, liquidity, and short maturity make a money market fund among the most conservative investment choices," says Joseph Lynagh, who manages all of the firm's money funds. "However, its return also reflects that conservative profile."

Ultra Short Term

The Ultra Short-Term Bond Fund is the firm's newest low-duration investment strategy.

With short-term interest rates still at historically low levels, money market funds have posted near-zero returns and are expected to continue to do so while the Fed maintains its current low interest rate policy.

In response, T. Rowe Price introduced the Ultra Short-Term Bond Fund last year for investors looking to earn a little more from their cash allocations.

The new fund seeks to provide a high level of income consistent with minimal fluctuations in principal value and liquidity. It takes slightly more interest rate risk than money market funds, however.

At the same time, the Ultra Short-Term Bond Fund seeks to provide greater price stability relative to longer-duration portfolios.

"Interest rates are low and are expected to remain low for an extended period of time, so this fund offers investors a tool to more actively manage their cash," says Lynagh, who also manages this fund.

"Investors might want to think about the fund as an alternative to their money market fund," Lynagh says. "It's a conservatively run portfolio, but it takes a little bit more investment risk as it seeks to produce a higher level of income for cash investors."

"Investors might want to think about the fund as an alternative to their money market fund," Lynagh says. "It's a conservatively run portfolio, but it takes a little bit more investment risk as it seeks to produce a higher level of income for cash investors."

Short Term

A little higher on the risk/reward spectrum is the Short-Term Bond Fund. This fund is a higher-yielding alternative to U.S. Treasuries and money market funds, but it takes more credit risk and has a higher duration.

Like the Ultra Short-Term Bond Fund, securities in this fund are primarily investment grade. The Short-Term Bond Fund seeks minimal fluctuation in principal value while providing a relatively stable share price.

The Short-Term Bond Fund also offers the potential for higher income relative to the Ultra Short-Term Bond Fund and money market funds.

For additional yield, the Short-Term Bond Fund takes sizable allocations in higher-yielding fixed income sectors. These include corporate and securitized bonds, such as mortgage-, commercial mortgage-, and asset-backed securities.

"The strategy is appropriate for investors seeking a diversified approach to investing in bonds while keeping duration shorter," Short-Term Bond Fund Manager Ted Wiese says.

With investing in higher-yielding sectors, T. Rowe Price's commitment to independent credit research becomes crucial for this fund. Says Wiese, "One of the most important factors for the Short-Term Bond Fund is our emphasis on finding high-quality, yet higher-yielding, bonds across many sectors."


For investors seeking the tax benefits of municipal bonds as well as a lower duration, there's the Tax-Free Short-Intermediate Fund

The income for this fund, unlike other low-duration options highlighted here, is exempt from federal taxes. This is most useful for those in the higher tax brackets, but the fund is suitable for all types of investors.

"The Tax-Free Short-Intermediate Fund is an excellent portfolio for investors looking to diversify within fixed income without taking a lot of interest rate or credit risk," manager Charlie Hill says.

By investing in several sectors of the municipal market, the Tax-Free Short-Intermediate Fund takes a diversified approach while seeking consistent income with modest price fluctuation.

"Like many low-duration strategies," Hill says, "the fund can be a good method for saving and investing with the potential to return more than a traditional savings account or money market. Plus, the income is free of federal taxes."

Munis have dealt with several bouts of volatility since the financial crisis—most recently prompted by the Detroit bankruptcy. But the firm's credit research comes into play again here, and most of this fund's assets are invested in investment-grade securities.

"The municipal market is full of high-quality opportunities for long-term investment," Hill says. "Parts of the market will continue to face pressure, but the overall landscape is full of well-managed issuers."

Because the municipal market is unique, investors should consult a tax professional before investing.

Short-Duration Bond Sectors: Yields and Duration Risks

Sources: Barclays, J.P. Morgan, and S&P/LSTA.

1Taxable-equivalent yield-to-worst assuming a 28% federal tax rate.

The chart shows the recent yields and durations for various short-duration fixed income sectors. Duration indicates the sensitivity of a bond's price to interest rates; the longer the duration, the greater risk of principal decline if rates rise. The converse is also true. Duration and yield data for money market funds are not plotted as both are near zero in the current low interest rate environment.

Ultra Short-Term Bond is based on the Barclays Short Term Government/Corporate Bond Index. Short-Term Bond is based on the Barclays 1—3 Year Government/Credit Bond Index. Tax-Free Short-Intermediate is based on the Barclays Muni 1—5 Year Blend Index. Floating Rate/Bank Loans is based on the S&P/LSTA Performing Loan Index.

Floating Rate

Another specialized fund for short-duration investing is the Floating Rate Fund. To minimize duration risk, the fund invests primarily in floating rate bank loans, also called leveraged loans.

The coupon rate that a bank loan pays its investors is tied to a short-term benchmark that is generally reset quarterly to reflect changes in interest rates. So as interest rates rise, these loans typically pay a higher coupon.

At the same time, the fund's overall credit quality is below investment grade. The portfolio holds more lower-rated securities compared with other short-duration funds, and it thus could experience more share price volatility.

So while it offers higher yields, this fund is more appropriate for investors who can tolerate a greater risk of principal loss in difficult credit environments.

This fund's profile is relatively unique within the fixed income spectrum. "The Floating Rate Fund offers investors an attractive yield relative to most other low-duration options," Manager Paul Massaro says. "However, investors should note the specific risks coupled with the noninvestment-grade universe."

Diversification cannot assure a profit or protect against loss in a declining market. An investment in a money market fund is not insured or guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund. Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise from current levels, bond fund total returns will decline and may even turn negative in the short term. Investments in lower-rated securities generally involve greater risk to principal than investments in higher-rated securities. Some income from tax-free funds may be subject to state and local taxes and the federal alternative minimum tax.