Money Market Funds Pros and Cons
The Hidden Danger of Ultra-Safe Money Markets
Money market mutual funds allow the average investor access to the rewards and relative safety of a variety of money market instruments. That's because these funds only invest in low-risk securities. Since they are low-risk, and they invest in short-term securities, they pay the very low dividends or interest that usually reflects short-term interest rates.
How Money Market Funds Work
These funds took off in the 1970s and had grown to nearly $3 trillion in total assets. Most money market instruments require investments of around $100,000 because they are geared to large businesses, banks and the government. Money market funds can buy these investments, and then sell shares to the public.
The largest money market funds are prime institutional funds. They make up $2.6 trillion of the total assets. That's where large corporations park their cash.
What They Invest In
Money markets invest in three types of low-risk securities. The first is U.S. Treasury bills, which are backed by the federal government.
The second is certificates of deposit. These are loans made to a bank for a short period. They are very safe, and they return a fixed interest rate for the life of the loan.
The third is commercial paper of very reliable companies. That is short-term debt that large companies can issue instead of going to the bank for a loan. Only well-regarded companies can do that, because the debt is nothing more than a promise from the company that it will be repaid. There are no assets backing the loan. However, the company usually has enough outstanding invoices, known as receivables, to support the loan. It just needs the money now to pay for day-to-day operations until future payments for orders come in.
It's like a payday loan for business. The company promises it will repay the debt within a year, if not sooner.
Money market funds are usually very safe. They allow easy access to the cash invested, and they don't require a minimum. Their rates are slightly below those of CDs that levy penalties if funds are withdrawn before they come due.
When interest rates are low, they may pay less than the rate of inflation. When that happens, fund investors are actually losing their purchasing power. However, many cannot afford to take the risk required to stay ahead of inflation, such as stocks, corporate bonds or hi-yield mutual funds.
Unlike bank money market accounts, they are not insured by the Federal Deposit Insurance Corporation.
How They Are Different From Other Mutual Funds
Unlike mutual funds that are invested in stocks, money market funds usually try to keep the net asset value of (NAV) of each share at a dollar. They are allowed to do so because they are invested in safe, short-term debt. This allows their investors to avoid changing the value on the books every day. They pay interest instead. Therefore, the value of the money market fund is dependent on the yield or interest rate, which does vary. It is very rare for the NAV to fall below a dollar, called breaking the buck, but it can happen if the investments do poorly.
When Money Markets Funds Almost Failed
On September 16, 2008, the $62 billion Reserve Primary Fund broke the buck. It was the nation's oldest money market fund. The money market had invested in Lehman Brothers short-term debt. When that investment bank went bankrupt, Reserve's NAV dropped to 97 cents.
Reserve Primary was the first money fund in 14 years to break the buck. This made panicked investors withdraw $139 billion out of money market funds in the next two days, according to IMoneyNet.
As a result, on September 19, 2008, the Treasury Department stepped in to guarantee money market funds. This run on money market funds made Treasury Secretary Henry Paulson realize that credit markets were shutting down, and he needed to submit the $700 billion bailout bill to Congress. On October 21, the Federal Reserve agreed to buy assets from money market funds that needed cash to pay for redemptions.
Source: "Money Market Funds," Securities and Exchange Commission.