Money market funds are mutual funds that feature safety, high liquidity and current income or interest in the form of dividends. They are the safest of mutual funds, but have not been insured in the past by the government. Millions of folks have parked trillions of dollars in these funds as a safe place to sit while awaiting other investment opportunity. When the stock market scares investors they tend to move their assets to money market funds.
Do not confuse these funds with money market accounts offered by banks. These are insured, and pay depositors an interest rate that is at the discretion of the bank. Money market funds pay market rates, or prevailing rates (short-term rates), minus modest expenses.
Except for a notable exception in 2008, retail investors (like you and me) have never faced the threat of losing money in these funds. Why? Let’s take a closer look.
Money market funds invest in high quality short-term IOU’s issued by the U.S. government, banks, and major corporations. Examples include T-bills, commercial paper, and short-term CD’s. Average maturity of this short-term debt is less than 90 days. So, when one IOU is paid off with interest, it is replaced by another.
Money funds have historically been viewed as very safe investments. U.S. T-bills are considered the safest investment in the world. High quality short-term debt has a great record for safety. No major corporation issuing debt can afford to default on any debt. That would lower their credit rating and make future borrowing more expensive and difficult.
Money market funds peg the value of their shares at $1. Share price does not flucuate. They pay investors interest in the form of dividends. As short-term interest rates in the economy change, the rate these funds pay track these changes. Money funds are very liquid. You can pull money out of them quickly and easily with no charges or fees. There are no sales charges to invest.
Remember, these funds do not declare interest rates like banks do. They are replacing their portfolio holdings on an ongoing basis. When money rates rise they are buying higher paying securities. When rates fall they are replacing higher rate paper with lower rate paper. They pass the interest onto investors, minus expenses which can be considerably less than one half of 1%. Thus, what they pay investors tracks or follows what money is actually worth in the money market.
So, if rates in the economy go up, investors automatically benefit from these higher interest rates. For example, my money market fund paid 13% in 1980, 17% for 1981, and 13% for the year 1982.
And then there’s the flip side. In early 2009 interest rates were at historical lows and money market fund rates were down to about one-fourth of 1%. The 3-month U.S. T-bill rate was even lower. Meanwhile, many banks were offering higher rates to attract and keep customers.
Some money funds specialize and invest only in U.S. government securities. Others invest in short-term municipal debt and offer tax-exempt income.
Keep in mind that money market funds in early 2009 were paying super low rates because interest rates were at record lows.