If you want a safe harbor for your cash that’s more flexible than a CD and pays greater yields than bank accounts, consider a money market fund.
What every money market fund promises its customers is that the value of each fund share will remain at $1. How much profit you make depends on the yield, which vacillates.
The $1 value of each share has been sacrosanct in the industry. The fear is that if a money market stumbles and drops in value below that $1 mark, investors will lose confidence in money markets and run into the waiting arms of banks offering FDIC-insured deposits. On the extremely rare occasion when a money market has appeared on the verge of “breaking the buck,” in industry jargon, its financial institution has propped it up.
The FDIC doesn’t insure money market funds, but there’s little need for concern. They’ve been extremely safe.
The recent experience of the Reserve fund—the nation’s oldest money market fund—was an anomaly.
In the fall of 2008, the Reserve fund became collateral damage for the subprime mortgage fiasco. The money market held debt from Lehman. Brothers, which became worthless when it declared bankruptcy.
Investors stampeded to pull their money out of the Reserve fund, which announced it would be forced to break the buck. The fund froze accounts; the inevitable lawsuits were filed. The Reserve fund’s collapse was so unnerving that the Treasury Department aggressively stepped in to restore confidence by announcing a temporary program to insure money market funds.
Only one other time in the history of money markets has a fund broken the buck. In 1994, the Community Bankers U.S. Government Money Fund liquidated its shares at ninety-six cents a pop. (No retail customers were hurt.)
Money markets remain a sound repository for cash. They’re heavily regulated by the U.S. Securities and Exchange Commission (SEC). Money markets invest in very short-term debt, such as U.S. Treasury bills, CDs (usually traded in $1 million units), and other highly liquid fixed-income securities.
Why should you care about money markets? In a word: yield.
Money market funds almost always offer a higher return than bank savings accounts, and they often also produce greater yields than six-and twelve-month certificates of deposit.
They also routinely beat the yields of bank money market accounts, which are known as MMAs. The MMA is a bank savings account and shouldn’t be confused with money market funds, which are actually mutual funds. Money market funds are routinely offered at brokerage firms and mutual fund companies, like Vanguard Group, Fidelity Investments, and Charles Schwab.
When short-term rates are rising, money market fund investors can benefit because fund managers continually add new debt to their portfolios, which carries higher yields. If you are invested in a CD, you’ll have to wait for it to mature before you can move money to something paying a higher yield (although some “step-up” CDs will permit you to make additional deposits and take advantage of higher yields).
Money markets are also attractive because of their liquidity, which makes them an ideal place to park cash. Invest in one and you can write checks off the account. Some money markets impose a minimum amount for checks, such as $500; others don’t. Money market funds also typically allow customers to redeem shares by phone.
As with other funds, to get the highest yields, look for money market funds that charge rock-bottom expenses.
You can find a fund’s fees by looking at its prospectus. A good place to check for low-cost funds is the large fund families: Vanguard, Fidelity, and Charles Schwab.
Don’t be snookered by “teaser” yields. To attract customers, some money market sponsors waive or reduce fees for a short period of time and hope that when they raise them, investors won’t notice. This information is buried in the prospectus, which few investors read.
If you’re keen on money market funds, there are different types from which to choose.
Taxable Money Markets
These provide the highest yields, but the returns are subject to federal and state taxes. They are the most popular type of money markets.
Tax-Free Money Markets
As the name suggests, you can skip paying federal taxes and—in some cases—state taxes too, but the yield is skimpier. The lineup in this category includes national tax-free funds and those designed for specific states. The state-specific funds allow an investor to sidestep state taxes. State-specific funds are more attractive in states with high income tax rates, like California, Massachusetts, and New York. A tax-free fund is going to make sense only if you’re in one of the higher tax brackets.