How Safe are Money Market Funds

How safe are money market mutual fund investments for 2010?

 “Like money in the bank?”

In the wake of the recent crisis, banks don’t sound so safe anymore. Money market mutual funds also used to be thought of as safe investments until September 16, 2008, when the Reserve Primary Fund, one of the nation’s largest money market funds, announced that the net asset value of its shares had “broken the buck,” falling to $0.97 per share. For years investors had all but ignored the fund industry’s standard hedge clause that stated, although the fund seeks to preserve the value of its shares at $1, there is no guarantee that they will be able to do so.

Industry regulations require money market mutual funds to maintain an average maturity of less than 90 days. This short time frame helps the funds keep their prices stable because investments with longer maturities face a greater likelihood that something could go wrong. Typical money market fund investments include U.S. Treasury securities backed by the “full faith and credit” of the U.S. government, sort-term corporate bonds (“commercial paper”) and Certificates of Deposit (CDs).

Although money market funds generally have had higher yields, until September of 2008 only bank deposits were government insured. Then the Treasury Department stepped forward with a guarantee program that would be triggered if a participating money market fund’s net asset value fell below $0.995 per share. The guarantee was designed to help stabilize these funds, but it was not automatic or free. The funds had to pay to participate in the program, which expired September 18, 1909. By that time the worst of the financial crisis appeared to be over. During the year it was in place, no money market funds “broke the buck” and the Treasury Department collected $1.2 billion in fees from participating funds.

What about money fund yields?

As the Treasury Department rushed to stabilize values, inflation rates dropped along with the overall pace of the U.S. economy. Many consumers cheered when the Federal Reserve Board let interest rates fall to historic lows, but yields on bonds also fell. As yields on many money market funds dropped to zero, many large fund families waived their management fees in order to lift their money fund’s yield up off the basement floor.

A variety of factors determine a money market fund’s yield. One is maturity. Longer-term bonds pay a higher rate than shorter-term issues. Money market funds can and do invest in securities maturing in months or even years, as long as the average maturity in the fund’s portfolio is less than 90 days.

Relative safety is another factor influencing yield. Lower-grade bonds have higher payouts than higher-quality issues in order to attract investors. For example, as of the beginning of March of 2010, Dreyfus Money Market Instrument/Government Securities Fund’s yield was 0.05%, while Fidelity Cash Reserves Fund had a yield of 0.07%. The Dreyfus fund is limited to top-quality government securities, while the Fidelity fund’s prospectus allows it to take more chances in exchange for higher income. Some money market funds invest in foreign securities, which can enhance yield at the cost of safety by exposing the portfolio to currency fluctuations.

Account size can also impact a money fund’s yield. Some of the highest-yielding money market funds are aimed at institutional investors. They have high minimum investment requirements and a low expense ratio. It costs the fund sponsor less to manage money for a few hundred corporations or fiduciaries than it does to manage thousands of smaller accounts for individuals.

What’s ahead for money market funds?

With the guarantee and the crisis that it triggered now history, regulators are seeking ways to maintain order in the market. The Securities and Exchange Commission (SEC) has been looking into changing the rules on the use of a stable share price – an idea that has faced stiff industry resistance. Other ideas include establishing something similar to the government’s FDIC insurance program provided to bank deposits.

In his annual letter to shareholders on March 3, 2010, Edward C. Johnson III, Chairman of mutual fund giant Fidelity, said, “The right amount of intelligent regulation of money market mutual funds can only be a major help to both investors and those responsible entities that need cash. A healthy marketplace leads to a fair marketplace….”

How safe are money market mutual funds?

Since no two money market funds are exactly alike, there is no blanket answer to this question, but some future regulatory changes seem inevitable. Since money market funds appeal to conservative investors, and to those who want to protect a portion of their savings from the volatility of other markets, these funds’ primary focus – and the thrust of any regulatory changes – is likely to remain on preserving the funds’ primary benefits: relative stability and convenience.