Money Market Mutual Funds

Money market mutual funds offer returns that are competitive with short-term CDs but, unlike CDs, they are 100% liquid, i.e., your money is not tied up for a specified period. Also, money market rates are much higher than the rates paid on deposits in regular checking and savings accounts and they usually include the convenience of limited check writing privileges.

Although the term "rate" is often used in conjunction with money market mutual funds, they don't actually pay interest. Rather, as mutual funds, the interest the funds make on their investments is paid to shareholders as dividends which are expressed as a rate of return. The dividends are taxed as ordinary income except in the case of tax-exempt funds.

There are distinct differences between money market mutual funds (MMFs) and money market accounts (MMAs). MMAs are offered through banks and credit unions and are treated much like other bank deposits. The amount of your deposit is fixed and you are paid an interest rate that is adjusted periodically with fluctuations in the credit markets. As MMAs are offered through banks and credit unions, they are FDIC insured like any other bank account. However, MMAs don't offer the convenience of being associated with your investment account.

In contrast, money market mutual funds manage their portfolios' assets with the intent of maintaining a per-share value of $1.00 and your rate of return fluctuates with the net asset value (NAV) of the funds' holdings. Money market funds are neither insured or guaranteed, which is one of the reasons they offer a higher return than money market accounts. Although they are not insured or guaranteed, money market mutual funds are considered to be very secure investments., especially those that are invested solely in U.S. Treasury debt.

The rate of return earned on money market funds varies with the credit markets and the types of securities held by the funds, thus the rate is not fixed or guaranteed for any specified period as it is with CDs, and it also may vary with the amount of money you have on deposit, with break points above which you earn a higher return.

Money market mutual funds invest in various short-term debt securities. These include U.S. Treasury securities, U.S. Government agency securities, commercial paper, CDs and municipal bonds, with the latter usually being held by tax-exempt money market funds. Some money market funds include some foreign securities that are denominated in U.S. dollars. The safest, and thus the ones that offer the lowest returns, are those that invest exclusively in U.S. Treasury securities.

Money market mutual funds are managed with the objective of maintaining a constant NAV of $1.00 per share, but this is not guaranteed. It's very unusual for a money market fund to lose money but it's been known to happen. The reason that losses are unlikely is that the securities money market funds invest in are short-term, no longer than 397 days to maturity, the weighted average maturity of a fund's portfolio can be no greater than 90 days, the securities must be high-quality and the funds can invest no more than 5% of their portfolios in any individual security.

Although money market mutual funds must invest in high-quality securities, AA or better, that might not be as good as it sounds. Many money market funds invest all or part of their assets in commercial paper, which is short term corporate debt. It used to be that commercial paper was fully backed by the issuing firms and truly short-term in nature. However, this has changed in recent times. Now many companies have replaced part of their long-term debt with commercial paper by continually rolling it forward, which is a risky strategy that can blow up in their faces if interest rates suddenly rise. But that's mild considering that asset-backed securities have slipped into the commercial paper market.

Somewhere along the line, some companies started issuing commercial paper that was backed by specific assets rather than being backed by all of the firms' assets, income and ability to issue long-term debt. Some of this asset-backed paper is backed by credit card debt and, you guessed it, sub-prime mortgages, amongst other things. Fortunately, this is short-term debt. So, when the investment bankers' amazing ability to convert sub-prime debt into high-quality asset-backed securities was exposed in the summer of 2007, there was a flight to quality in the money market and the money market funds started purging their portfolios of this junk by replacing maturing issues with traditional commercial paper. This resulted in slightly lower rates of returns on money market funds but has served to bolster their security. It should be noted that asset backed paper is implicitly backed by the companies that issued it. The solid companies that rely heavily on commercial paper for working capital are not likely to default on their asset backed paper, as to do so would seriously impair their future ability to raise short-term capital.

As of November 2007 there was still a considerable amount of this junk in money market mutual funds, but the amount decreases every day as the debt matures. Remember, 397 days is the maximum term allowed and the maximum weighted average maturity for a portfolio is 90 days, so it shouldn't take too much longer to rid the portfolios of most of this stuff. But there will always be a few who will do just about anything to offer higher returns than their competitors, so as long as low-quality debt securities can be repackaged and passed off as investment grade asset-backed securities, you can bet that some funds will buy it, so always read the prospectus.

These days, most brokerage accounts and many mutual fund accounts are set up as "sweep accounts." All cash in a sweep account is swept into a money market fund on a regular basis, usually daily. If you deposit money in your account but don't invest it right away, it earns interest in the money market fund. Any distributions from your investments that aren't automatically reinvested also will be deposited in your money market fund where they will earn interest. And most sweep accounts include check writing privileges, although there will be restrictions as to how many checks you can write per month.

Sweep accounts are meant to be a place to temporarily park cash and usually pay a lower rate of interest than regular money market mutual funds. So, if you have a significant amount of cash that you plan to hold for more than a few weeks or if you customarily keep a significant amount of cash on hand, you should put it in a regular money market mutual fund. Money market mutual funds are a good place to put the proceeds from CDs and bonds that have matured and which you plan on using for living expenses. Just keep in mind any restrictions as to the number of checks you can write per month, as it may be necessary to transfer funds to a regular checking account to pay your bills, etc. A good option for this is an interest-bearing checking account that pays a rate that is only slightly less than what you would make with a money market mutual fund.

Money market mutual funds are considered to be cash equivalents and cash is actually a good diversifier. Cash is slightly negatively correlated to the general market and has little of no correlation with other non-debt securities. Cash's correlation to debt securities is very high for short-term debt and decreases as durations increase.

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