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Of Mutual Interest

Don’t count out money market mutual funds

By Mark Jewell
Associated Press / February 7, 2010

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It’s hard to market any investment when its annual yield starts with a zero.

Take money market mutual funds. Yields for the safest of safe-harbor investments have been creeping close to zero for more than a year. Normally you’d expect money funds to earn 2 percent to 4 percent a year, but now the average yield is down to around 0.03 percent - a few hundredths of a penny for each dollar put in.

That’s a record low since money funds emerged as alternatives to bank accounts for keeping money safe and quickly accessible. Typically, you get a slightly higher yield from a money fund than from an interest-bearing bank account offering comparable check-writing privileges.

Unlike bank accounts, some money funds dish out returns tax-free. What’s more, banks face tighter limits on the types of investments they make and must pay higher overhead to operate bank branches.

Bank or money fund, yields are just plain low now because interest rates are near zero. But with money funds, there could be even more shrinkage soon. Last week the Securities and Exchange Commission approved rules to make money funds safer.

With investing, more safety means lower returns, and money funds are no exception. Don’t expect any big drop - yields don’t have much lower to go. And most managers have been running their funds more conservatively for months now in anticipation of the new rules.

Still, if yields may become even slightly smaller, why stick with money funds? Why not join the crowd that has pulled some $700 billion out of money funds since their assets peaked at $3.9 trillion a year ago?

Well, look before you leap, even if money funds stink now. Once interest rates rise from their current near-zero levels, they could come out looking pretty good. Keep in mind, it’s only a matter of when rates will rise.

Take, for example, short-term bond funds. They’re an alternative many investors are turning to so they can squeeze out a bit more yield than they’d get from money funds.

But good luck if the unexpected happens, and you suddenly need to access your money just as interest rates are rising. When rates climb, bond prices fall. So you could be getting less back than you put in, unlike with money funds offering at least a dollar-for-dollar return.

“The risk of rising rates is that it tends to blow up bonds,’’ says Peter Crane of fund industry researcher Crane Data, publisher of the newsletter Money Fund Intelligence.

Rising rates also could sting investors plucking cash from a money fund to reinvest in stocks.

The bull market that started last March owes much to low interest rates that have made it cheap to borrow, even if banks are now choosier in deciding who’s creditworthy. But that rally could go into reverse once it appears the Federal Reserve is poised to boost rates when the economy really gets going again, and the inflation threat returns. The government is already removing other supports propping up a shaky economy, so interest rates in the market could begin to tick up even before the Fed raises its benchmark rate. Many think the Fed could move within six months to a year.

So why are money funds safer than other options when rates rise? While money funds’ returns may vary, you can expect a dollar back for each buck you put in, and then some.

While that “some’’ isn’t much, it grows in tandem with interest rates. That’s because the investments that money funds hold are short-term and frequently turn over - the average maturity of bonds that money funds hold now is about seven weeks. Their investments are in safe IOUs, such as government Treasurys and commercial paper that companies sell to meet cash-flow needs like payroll.

When a money fund replaces matured bonds with new ones, they’ll carry the higher yields that the market dictates once interest rates rise. That means a fund earning a near-zero yield could move up to a more respectable 1 percent within a few weeks after interest rates rise, and its portfolio turns over.

In contrast, when short-term bond funds reinvest as rates tick higher, their portfolios turn over more slowly. As for putting cash in banks, money fund yields typically inch up faster in response to rising rates than interest paid on checking accounts.

Money funds aren’t viable options to anchor a portfolio long-term. But don’t count them out as sizable piece of a nest egg short-term, since interest rates have nowhere to go but up.

“It’s been a real test the last 18 months, and the industry has done pretty well,’’ says Michael Rosella, a lawyer with the firm Paul Hastings who advises money-fund managers. “Most of the pain is over.’’

And, of course, unlike other investments and bank certificates of deposit, money funds are less likely to saddle you with withdrawal fees or delays if you need cash quickly. “Liquidity isn’t important,’’ says Crane, “until you need it.’’