What Are Money Market Funds?
Money market funds are mutual funds with low risk and low returns. They only invest in low-risk debt securities. These include short-term Treasury notes, municipal bonds, or high-grade corporate debt.
Since they are low-risk, they pay low dividends that usually reflects short-term interest rates.
How Money Market Funds Work
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 dividends instead.
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.
Types of Money Market Funds
Money markets invest in three types of low-risk securities. The first is U.S. Treasury bills, which are backed by the federal government. There is $1.2 trillion invested in this.
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. There is $228 billion invested in these.
The third is the 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.
Usually, 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. There is $243 billion invested in this type of money market fund.
Pros and Cons
No minimum requirement
Don't keep up with inflation
Not insured by the FDIC
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 Their rates are slightly below those of CDs that levy penalties if funds are withdrawn before they come due.
The worst disadvantage is that money market funds are not insured by the Federal Deposit Insurance Corporation (FDIC).
When interest rates are low, these funds may pay less than the rate of inflation. When that happens, fund investors are actually losing their purchasing power. They are still a good investment for those who cannot afford to take the risk required to stay ahead of inflation. That includes investments such as stocks, corporate bonds, or hi-yield mutual funds.
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 $172 billion out of money market funds. During a typical week, only about $7 billion is withdrawn.
If the run on money markets had continued, companies couldn't get money to fund their day-to-day operations.
In just a few weeks, shippers wouldn’t have had the cash to deliver food to grocery stores. We were that close to a complete collapse.
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.