OREANDA-NEWS. Short-term bond funds have garnered attention as potential alternatives to prime money market funds in light of reforms, but closer scrutiny is warranted by investors due to a lack of standardization and widely varying risks, according to a new report from Fitch Ratings.

Most of the cash leaving prime funds has gone into government money funds ahead of money fund reform taking effect Oct. 14, but investors have shown an interest in short-term bond funds as a higher yielding alternative, and fund managers have responded by launching numerous new offerings. One of the draws for investors is the absence of the liquidity fees and redemptions gates feature that money funds will have with reform.

"Short term bond-funds may attract investors, however there is less transparency in these funds than money funds," said Greg Fayvilevich, Senior Director, Fitch Ratings.

The higher yields on short-term bond funds reflect the additional interest rate, credit, and liquidity risks. The newest type of short-term bond funds launched by fund managers in response to the reforms tends to assume slightly higher duration and credit risk than allowed under Rule 2a7, up to one year of duration and a small allowance for 'BBB' rated credits. In the broader universe of short-term bond funds, duration risk is higher, and many funds buy non-investment-grade securities.

Liquidity risk is another differentiating factor, since money funds are used as cash management vehicles, but short-term bond funds are generally viewed as appropriate for longer time horizon reserve or strategic investments. This is reflected in the funds' portfolio compositions, with money funds allocating more to liquid government securities while short-term bond funds invest more in less liquid and higher yielding ABS. The difference in risk is reflected in the funds' expected volatility.

Fitch has rated a number of short-term bond funds marketed to investors as MMF alternatives and, in light of the focus on the sector, recently updated its Global Bond Fund Rating Criteria report. The changes are meant to provide investors with additional transparency, which is often lacking in short-term bond funds compared to the information available on money funds.