A money market fund is a mutual fund that invests in short-term (maturity is generally less than one year) fixed investments and pays interest to the investor. Investors, typically, think of money markets as a safe investment. In most cases, they are. The per-share price of money market funds normally remains constant at $1 per share, although this is not guaranteed. Therefore, it is important for an investor to know how a money market fund is invested before a purchase is made.
Investors hold money market funds for many reasons, including emergency reserves, short-term cash needs, or as an investment with little risk to principal. Some use money markets through a fund family as a savings or checking account, because rates are often higher than those offered through banks.
There are two basic types of money markets: taxable and tax-free.
Taxable Money Markets
As the name infers, earnings on a “taxable” money fund are subject to federal and state income taxes. Exceptions to this include direct-obligation-only funds, which only invest in direct obligations of the U.S. government such as T-bills, Ginnie Mae (GNMA) and Federal Home Administration (FHA) agencies, and treasury-only funds, which are free from state income taxes in most states. The most common instruments found in taxable money markets are:
Treasury Bills (T-bills):
U.S. Treasury securities that are backed by the full faith and credit of the U.S. government. T-bills have short-term maturities, generally up to one year.
Repurchase Agreements (Repos):
Collateralized overnight loans an investor makes to a bank or securities dealer. An investor purchases a security (usually a U.S. Government security) from the borrower (bank or dealer). The borrower repurchases the security on a specified date at an agreed upon price. The return is the difference between the negotiated price and the repurchase price.
Commercial Paper:
Unsecured, corporate debt issued by banks and corporations. Maturities range from 2-270 days. Most are discounted, but some do pay interest. Credit risk is associated with commercial paper. However, for the most part, these are backed by bank lines of credit.
Certificates of Deposit (CDs):
Instruments issued by banks. They pay interest rates that are set by the market place. Maturities can range from weeks to years.
Eurodollar CDs:
CDs that are issued by banks outside the United States, usually in London. The interest is paid in U.S. dollars, but the interest rate paid is based on the LIBOR (London Interbank Offered Rate).
Bankers’ Acceptances:
Short-term credit investments created by a non-financial firm and guaranteed by a bank. They are mainly used by corporations involved in international trade, as a method of payment for merchandise sold in import-export trade. Both the bank and the buyer of the merchandise secures the banker's acceptance.
Government Agency Securities:
Instruments issued by U.S. government agencies. Generally, they have high credit ratings. Because they are not considered government obligations, these instrument(s) are not backed by the full faith and credit of the U.S. government, rather they are a moral obligation. Examples include Federal National Mortgage, Federal Land Bank and the Small Business Administration.
Tax-Exempt Money Funds
Tax-exempt money market funds are most appropriate for those investors in high tax brackets. These funds invest in short-term obligations and tax-exempt instruments (usually with maturities of three to six months). The interest paid is usually lower than that paid on the taxable money markets, but is exempt from federal income taxes. In some instances, they are also exempt from state and local taxes. The most common instruments found in tax-exempt money markets are:
General Obligation Bonds (GO bond):
Municipal bond backed by the full faith and credit of a municipality. Repaid by revenue and borrowings.
Revenue Bonds:
Issued by a municipality to finance revenue-producing projects like toll roads, airports or hospitals. Supported solely by the revenues of the project.
Tax-Exempt Commercial Paper:
Non-profit organizations, universities and state and local municipalities generally issue this type commercial paper.
Tax Anticipation Notes (TAN):
Issued by state or local municipality to finance spending on a project pending receipt of expected tax payments.
Bond Anticipation Notes (BAN):
Issued by state or local municipality to be paid off with the proceeds of an upcoming bond issue.
Revenue Anticipation Notes (RAN):
Issued by municipality to be paid off with anticipated revenues such as from sales tax.
Construction Loan Notes (CLN):
Issued by municipality to finance construction of housing projects. These are normally repaid from proceeds of a long-term bond issue.
The instruments listed above are the primary investments found in money market funds. However, some money markets also contain junk bonds, money market derivatives and foreign debt securities. With these underlying instruments, money market investors are exposed to some credit risk and the risk of default, albeit limited. Companies have been known to default on their commercial paper. An extreme case was Orange County, California. It declared bankruptcy in 1994; thereby, defaulting on their bonds.
Money market funds are certainly more appropriate for short-term liquidity needs than equity funds or stocks. However, no fund, not even a money market fund, is completely safe. Before investing in a money market fund, always read the prospectus to determine if it is a good investment choice for you and your investment strategy.
For more information on money market funds, contact The Henssler Financial Group at 770-429-9166, or comments@henssler.com.
