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Christine Benz: Hi, I'm Christine Benz for With the threat of rising interest rates looming large, many investors are concerned about shielding their portfolios from excessive interest-rate sensitivity. Joining me to discuss some of Morningstar's favorite short-term bond funds is Eric Jacobson, he is a senior analyst with Morningstar.

Eric thank you so much for being here.

Eric Jacobson: Hi, Christine. It's great to be with you.

Benz: Eric, let's start by discussing the short-term bond category. I've been hearing from some of our users that they are using some of these funds to stand in for their cash holdings. Is that a good strategy in your view?

Jacobson: Christine, I think the real key issue is what you said about standing in for cash. The short answer is that short-term bond funds aren't cash. Now if you are really cognizant of what they are and what they hold, then it's all right I guess to stretch out a little bit, be willing to take on a little bit more interest-rate risk in terms of what can happen over a market cycle, and more importantly, I think in many cases is understand that you're probably going to take on some credit risk that you may not otherwise realize is there, depending on the fund that you're investing in.

Benz: So you can pick up some extra income, but you probably won't have that net asset value stability day in and day out?

Jacobson: Yes, in most cases it's pretty trivial, but for people who really, really prize and value unbelievable stability, if you will, in that part of their portfolio, they do need to understand that some risk exists there. Any time you want to take a look at what your worst-case scenario might look like, you probably want to look at 2008 and see what happened to your fund in that period of time.

In most cases you're only talking about a couple of percentage points of change, but you need to make sure you're comfortable with that because that's probably about as bad as things are normally going to get in the midst of any kind of crisis.

Benz: Let's discuss this ultra-short-term bond category. We've recently seen some fairly new funds coming to market. What's your take on that category, and that's another place where investors have been using those funds to supplant cash? I'm guessing you would say that investors should really know the risks in their funds and know what they are doing before investing in them.

Jacobson: Exactly so, and part of the reason for that admonition is the fact that so many of these funds market themselves as just a step above cash but truly need to take on some additional risk in order to be viable products. And what I mean by that is they almost always charge enough that they got to hit a hurdle in terms of how much their income they are delivering just to be able to bring to you the yield that they are promising, and they've got to often take either interest-rate or credit risk to get there. So if it's an ultra-short-term fund, in particular, usually that's going to come through some sort of credit risk.

Now you may or may not be able to see it definitively based on the credit ratings, depending on what kind of securities [the fund is] investing in. So you want to take a look at the credit rating breakdown of the portfolio as well as what kind of sectors the portfolio is invested in.


Benz: For investors who are looking to allocate a portion of their portfolios to the short-term bond category, I want to go through what you think are some of the best options, some of the top-rated picks from our analysts. One is an index fund; it's very vanilla in a lot of ways. Let's talk about Vanguard Short-Term Bond Index.

Johnson: Sure. Well that fund is really as you said sort of a plain-vanilla offering. It's mostly government securities and corporate bonds. I don't believe there are any mortgages in that portfolio, and that makes it a little bit more predictable, a little more plain-vanilla. You are taking on a little bit of credit risk there in terms of that corporate portfolio, but it's pretty much all high-grade, investment-grade, corporate exposure.

Of course the big selling point of Vanguard is it's simple. They're not doing a lot of crazy things in that portfolio being an index fund, and it's going to be cheap. So that's a really nice plain-vanilla option especially for those folks who understand that they're taking on a little bit more risk than cash as we talked about, but they're not going crazy.

Benz: The next fund [is T. Rowe Price Short-Term Bond]. You say it's a moderate fund in a lot of ways; that's really in keeping with T. Rowe's moderate stance on a lot of different products.

Jacobson: That's exactly right. It's not the safest option if you will. It takes on a little bit more credit risk than most plain-vanilla short-term bond funds, but as you say, it's pretty moderate. It uses a lot of investment-grade corporate exposure to generate the kind of income and return potential that they want to target for a short-term bond fund, but it doesn't do a lot of the riskier things that much more aggressive funds do that will rally in a big credit market, for example, if they have high yield or if they've got foreign and emerging markets.

Benz: Eric, the last fund you want to talk about is PIMCO Low Duration. That one takes on a little more risk still. Let's talk about that portfolio and why the analysts like it so much?

Jacobson: It really depends where you look in the portfolio; part of it looks pretty tame. It's got a lot of high quality, short duration, U.S. mortgages, and so forth. Where it separates itself is with a little bit of spice in its corporate portfolio with financials. It also holds a little bit of high yield, but even more notably it holds a decent amount of both non-U.S.-developed foreign bonds as well as some emerging-markets debt. And that's where, as I said, it spices things up a little bit.

But again you are dealing with PIMCO here. You've got Bill Gross and the short-term desk running this portfolio. They're not infallible certainly. I wouldn't want anybody to think that even though you can look and see a tremendous long-term record, but the fact of the matter is they have delivered and it's a good choice if you are willing to take on a little bit more aggressiveness in exchange for what you hope will be really topnotch management making good decisions.

Benz: Eric, I can see why if you could buy the fund in, say, a 401(k) plan or something like that and avoid the sales charges and maybe get a cheap institutional share class, then the fund is a good deal. But the A shares of the PIMCO Low Duration fund have, I think, an 80-basis-point expense ratio and a 2.25% sales charge. Given how low yields are right now, is that fund really going to be able to make up for those hurdles that are pretty much built in.

Jacobson: That's part and parcel of that slightly more aggressive strategy. So in other words, they are pretty cognizant of the fact that they have to beat that hurdle, so they are taking on a little bit more risk in order to do that. I think there are two main issues. Are you going to hold the fund for the long term and beat the cost of that load, which is there to compensate your investment intermediary? And then is there going to be enough return to top that 80 basis points? That's a little bit of a trickier call. I think it probably will, but this fund in its best application is really going to be for one of the lower-priced share classes.

Benz: Eric, thank you so much for being here to provide a survey of the short-term bond universe.

Jacobson: My pleasure Christine. Good to talk to you.

Benz: Thanks for watching. I am Christine Benz for

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