Short Bond Funds Serve As Haven For Yield-Seeking Buyers

Investors unhappy with painfully low yields on money market funds have been pouring into short-term bond funds, a trend that has helped maintain strong demand for corporate debt.

But even when bond markets start anticipating a rise in interest rates, which would eat into bond returns and could send these conservative investors fleeing, some observers say that corporate debt should still perform well.

"I think the Fed would only be comfortable raising rates - or telegraphing raising rates - if the economy is on solid footing," said Robert Auwaerter, principal and head of the fixed income group at Vanguard. That means stronger corporate balance sheets that are attractive to bond investors.

Indeed, some people think that investors looking to pare their exposure to longer-term bonds by moving into short-term bond funds could offset those who quit short-term bond funds and return to money markets.

While some may go from longer-term bonds into other asset classes, such as stocks, "for those investors in fixed-income, short-term bond funds are the place to be," said Robert Adler, head of Lipper FMI, Americas.

Money market funds have seen billions in outflows every month last year except January, according to Lipper data. Meanwhile, funds with bonds maturing in one to three years saw inflows every month - peaking at $7.3 billion in September.

Fund companies say much of the cash fleeing money markets headed into their short-term bond funds, which offer less safety but higher yields. Cash in Vanguard's short-term investment-grade bond fund skyrocketed by 68% to $33 billion in 2009, and the short-term bond index fund saw a 61% increase to $16 billion, Auwaerter said. T. Rowe Price's short-term bond fund doubled to $4 billion, said portfolio manager Ted Wiese.

The pace has slowed, but inflows are expected to remain steady as a rise in interest rates is widely seen as occurring toward the end of the year.

"Until the Fed starts to raise rates, short-term bond funds will likely see growth from conservative investors looking for yield," Wiese said.

The trend has been good for companies that want to lock in cheap rates for a three-year note, for instance, as compared to commercial paper, which matures in two to 270 days. This advantage is particularly valuable as bank lending remains constrained.

"If you're a company looking to reduce your cost of funding, a short term bond fund is an ideal vehicle to issue into in order to take out bank loans," said Ashish Shah, co-head of credit strategy at Barclays Capital.

That has helped changed the way companies borrow recently, when earlier in the crisis investors were demanding longer-term bonds at higher yields. Last year, for example, 38% of all U.S.-marketed investment-grade bonds matured between 18 months and five years, compared with 26% in 2008, according to Dealogic. On Monday, Procter & Gamble sold a $1.25 billion note due August 2012.

Some participants also point to recently enacted rules from the Securities and Exchange Commission, aimed at strengthening money markets, as possibly depressing money market yields further.

Still, the flight of cash from bond funds as the Fed signals a rise in rates could weaken corporate bond spreads down the road. Those bullish on credit, however, say that could be a buying opportunity if the economy continues to show improvement.

"I think the wind will be at the back of credit," said Matt Eagan, portfolio manager at Loomis, Sayles & Co. "Default rates are less of a concern, and that means you'll keep more of your coupon and your principal."

-By Romy Varghese, Dow Jones Newswires; 215-656-8263; romy.varghese@dowjones.com

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