For nearly three years, the stock market went up, interest rates fell ever lower, and money-market funds were just plain boring. Then came 1994.
Rising rates and unsettling volatility in the stock and bond markets have made money funds much more interesting. Not only do they provide a great place to hide out for a while, but their otherwise-lackluster yields have been edging up. Since Feb. 4, the first time the Federal Reserve raised short-term rates, the seven-day average yield on all taxable money funds has moved from 2.68% to 3.82%, according to Money Fund Report. The top-ranked Benham Prime Money Market Fund returns a not-too-shabby 4.59%.
But not all money markets are created equal. There are more than 1,000 to choose from--in several categories. Even with this most conservative brand of mutual fund, you should consider what risks you are willing to take, as well as the impact of taxes and expenses.
BAILOUTS. Case in point: Some money funds had to be bailed out recently, so their share prices wouldn't fall below $1. In an effort to increase yields, these funds purchased certain derivative securities, which plummeted in value when rates rose and had to be sold at a loss. BankAmerica, for one, covered losses of $67 million in two of its Pacific Horizon funds in June. This doesn't mean money fund shareholders should panic, says Robert Plaze, assistant director of the Securities and Exchange Commission's investment management division. At worst, these funds' net asset value would have temporarily fallen to 98 cents or 99 cents before returning to $1.
But these bailouts proved that some money-market fund managers are willing to pursue more aggressive strategies than others. While BankAmerica says the structured notes it was forced to sell at a loss were "permissible investments," some pros were amazed a money-fund manager would buy them.
"Derivatives of one sort or another are almost unavoidable," says Ian MacKinnon, who heads Vanguard Group's fixed-income unit. But while some are safe and liquid, others aren't appropriate for money funds, he says, even though they may be ideal for other kinds of bond funds. In a June 30 letter, the SEC stated that the following derivatives were unsuitable for money funds: "inverse floaters," "leveraged floaters," "CMT floaters," "capped floaters," "range floaters," "dual-index floaters," and "COFI floaters." Partly because of the letter, funds that dabbled in risky derivatives have probably sold them and taken their losses, says Teresa Redinger, editor of Money Fund Report.
REPO DEALS. But if the idea of exposing your cash reserves to exotic securities makes you nervous, ask the fund about its policy on derivatives. "We're getting those calls," says Amy O'Donnell, portfolio manager of taxable money-market funds at Benham. "It's very comforting for us to say we don't own the problematic ones." Benham Prime Money Market Fund enjoys the No.1 spot primarily because it opened last November and has been able to pack its portfolio with higher-yielding securities as assets have grown.
To avoid derivatives completely, you can stick with 100% U.S. Treasury funds. Their average yield mf 3.57% isn't too exciting, but you may get a boost: They're exempt from most state taxes.
For a little more yield and a touch more risk, some money funds invest in treasuries and repurchase agreements, or "repos." In a typical repo deal, a fund would buy a batch of government-agency securities from a bond dealer, agreeing to sell them back the next day at the same price--plus a little interest. Funds pick up a smidgen of credit risk but have the securities as collateral if the bond dealer can't make good on the repurchase agreement.
The next-riskiest money funds own government and agency debt, so they have virtually no credit risk. But some of them have gotten into trouble with structured notes issued by agencies such as Ginnie Mae and Sallie Mae.
General-purpose funds can buy any of the above-mentioned securities, plus high-quality commercial paper issued by corporations. There is some credit risk involved, but the funds are still quite safe because only financially strong companies would offer high-quality paper. So-called second-tier funds buy lower-quality paper. But there are only seven available, since most investors expect top-rated holdings in a money fund.
Tax-free money funds have--so far--avoided trouble with derivatives, because the exotic securities aren't available for that type of fund. But that's not enough reason to choose a tax-free fund. Since prices of municipal debt have held up much better than government and corporate debt this year, the spread between tax-exempt and taxable money funds is now a lot wider. People in the highest tax bracket may be able to find a tax-exempt fund that will generate a better aftertax yield than a taxable fund. But that is getting harder to do.
Compare how you would fare in taxable vs. tax-exempt funds by subtracting your tax bracket from 1 and dividing that into the tax-exempt yield times 100. Using this formula, a tax-free yield of 1.84% (the average for retail tax-free funds) for someone in the 39.6% bracket compares with a taxable yield of 3.05%. The average taxable fund yields 3.77%. Only state-specific funds are exempt from local as well as federal taxes. And some treasury-only funds are exempt from state taxes but not federal ones. You may need an accountant to determine your best aftertax return.
"GRADATIONS." You should also look at expenses. In the second quarter of 1994, 57% of money funds were waiving all or part of their charges temporarily, and the average expense ratio was 0.58%, according to Money Fund Report. But fee-waivers can be misleading, since charges can be reinstated at any time. Vanguard doesn't waive them but offers fixed low expenses: 0.32% for its Money Market Reserve funds and 0.15% for its $50,000-minimum Admiral series. Other companies lower expenses for people who sock away a lot of cash.
Although different money funds have different risk levels, "we're talking about very small gradations here," says Sanford Bragg, managing director of Standard & Poor's Ratings Group. Still, since safety is paramount to money-fund investors, you should know exactly what you're buying into.
THEY'RE NOT ALL THE SAME Money-Market Fund Investments Yield* 100% U.S. Highest safety. Federal tax applies; 3.57% TREASURY returns tax-exempt in most states. U.S. TREASURY Participates in repurchase agreements, 3.66% AND REPO in which a bond dealer sells securities, agreeing to buy them back on a certain date at a specified price. U.S. Buys securities issued by U.S. 3.66% GOVERNMENT agencies, such as the Student Loan AND AGENCIES Marketing Assn. The funds have no credit risk, but some have taken on market risk by purchasing derivatives. GENERAL Can buy high-quality commercial 3.77% PURPOSE paper of corporations, which adds some credit risk. May gamble with derivatives. A handful of "second-tier" funds purchase lower-quality paper for a higher yield (4.14%). TAX-FREE Invests in short-term municipal 1.84%** securities, such as tax anticipation notes. Exempt from federal taxes. Only state-specific funds avoid state taxes. *Compound annualized 7-day yield, including reinvested dividends and capital gains for the week of July 6-12. **3.05% tax-equivalent; 39.6% tax bracket DATA: IBC/DONOGHUE INC., BUSINESS WEEK