The Fabulous Yields, and Lurking Risks, of Money Market Funds

Since the Federal Reserve began raising interest rates last year to combat inflation, the markets have been volatile.

Stocks and bonds lost money. Costs of financing a home, car or small credit card purchase have increased. Two regional U.S. bank failed and required bailouts. Worries about a possible economic recession are spreading.

Money market mutual funds have had a great year. Crane Data's largest money funds pay more than 4.6 per cent interest and a few have yields of around 5 percent.

The Fed Funds rate is set by the central banks. Fed funds rates are now around 4.83 percent. This is a burden for those who need to borrow funds, and it's done deliberately: the Fed is increasing rates to slow down the economy in order to curb inflation.

What is painful for the borrower, can be a boon for those who have money set aside for bills and need to store it. Some banks are raising the rates on savings accounts and certificates of deposit in an effort to retain customers. However, most bank deposits still pay next to nothing.

Money market funds are a magnet for investors. The assets of money market funds have grown to $5.6 trillion from $5.2 trillion when the Fed first began to talk about interest rate hikes in December 2021. Money market funds will continue to grow if the Fed keeps rates at current levels or increases them.

Money market funds have been my go-to investment for years. They are relatively safe, but not completely. It's okay to invest some money in these funds, but you should be careful and watch your back.

The Landscape Shifts

When money market rates rose from near zero to 0.7 percent in June, I said that it was time to shop around.

If you are willing to take action, the days of receiving nothing in return for keeping your money with a financial institution is over. Money market rates began to soar as soon as interest rates rose, creating a huge gap between them and bank deposit rates.

This gap has now reached its highest level in decades. Money market funds have become more popular, and not only for corporate financial officers, who use them to store money. They also offer high returns for ordinary people.

Imagine you have $10,000 in a safe. If you keep it in your checking account, you'll get nothing or almost nothing. If you keep it in an investment fund that pays 5 percent per year, you'll receive $500.

You won't get rich. You could lose purchasing power when inflation is taken into account if you depend on consumer prices. Money market yields have just begun to approach the Consumer Price Index annual rate, which was 5% in March. However, compared to nothing, $500 seems like a lot.

Apple, for instance, is partnering with Goldman Sachs and marketing a 4.15 % interest account. Other financial institutions also compete for attention but their rates are generally behind money market rates.

If you're an investor in money market funds, then rising interest rates are something to be delighted about. As always, in finance, there are costs associated with any benefit.

Known vulnerabilities

This record is comforting to me because it shows that money market funds have never suffered major losses.

The funds do not come without any risk.

There are indications that the banks that have suffered losses in deposits, particularly smaller ones, may be affected by their popularity. These losses, which led to the collapse of Silicon Valley Bank and Signature Bank in November last year, have caused stress throughout the financial system.

According to government statistics, more than $560 billion of deposits left the commercial banking sector this year up until April 5. Crane Data reports that more than $442 million was deposited into money market funds. This is great news for fund investors but not for financial institutions.

Individual companies can be a good example. Charles Schwab's banking division, which just released its quarterly earnings report, lost $41 billion of deposits in the first quarter. Schwab's money-market funds, on the other hand, gained $80 billion.

The shift in Schwab's business model has been a huge boon for its customers. This means that their income will increase dramatically. The company's profits will be affected, but not for the shareholders. Schwab claims that the company is strong enough to deal with this shift. It may be true, but it is not the case that all financial institutions have a solid foundation.

The financial regulators monitor these issues closely.

Money Market Runs

Money market funds are also subject to periodic runs.

Money market funds have only failed to pay out 100 cents for every dollar invested. This is called 'breaking the buck', in Wall Street parlance. Despite headaches and lengthy payment delays, there were no losses.

There have been many close calls. In a 2012 report, the Federal Reserve Bank of Boston discovered that money market fund companies quietly injected money into the funds to make sure that they could pay their investors the full amount of money that was expected.

Remember that the Fed was forced to restore calm in 2008 during the money market run and again in 2020 during a short crisis at the beginning of the coronavirus epidemic. Securities and Exchange Commission (SEC), which regulates money-market funds, has already tightened their rules twice and is now proposing further changes.

The federal government's involvement in the money market has become a regular thing. Money market funds have relied more on the Federal Reserve Bank of New York's reverse repurchase agreements, or "reverse repo" operations, since the 2020 crisis. The Fed sells overnight Treasury securities to many money market funds. More than $2.2 trillion worth of securities are tethered to this market.

Janet L. Yellen, Treasury Secretary in the midst the latest banking crisis on March 30, targeted money market funds with special concern. Money market funds are a place where the vulnerability of the system has been clearly demonstrated. These funds are used widely by institutional and retail investors to manage cash. They can be a good alternative to bank deposits.

Ms. Yellen acknowledged the tightening of regulations that had already taken place, but said that more work was needed. She said that the financial stability risks associated with money market funds and open-end mutual funds had not been adequately addressed.

How to Use Them

Today, I can stash cash in a number of different places.

There are accounts with a global commercial bank as well as a credit union. Also, there is an online savings bank that offers a high-yielding F.D.I.C. insured account, and a money-market fund at a reputable, large asset management firm. In the last year or so, I have kept money in each of these accounts, but the money-market fund is my favorite because it produces steady cash.

When the Fed lowers interest rates -- which could be soon, if there is a recession or in many months, if inflation persists -- I will reduce my money-market funds.

Money market funds can be risky. I use what is called a government fund to minimize my risk. This fund only holds Treasury bills, securities issued by the U.S. Government and U.S. Agencies, as well as reverse repo securities held at the Fed. This eliminates the risk that my fund would hold securities issued from a private company which goes bankrupt, as Lehman Brothers in 2008 did.

Treasury bills also aren't 100% safe, especially with the federal debt limit looming. As mind-blowing as it may seem, the U.S. could default on its debt. Money market funds avoid Treasury bills which could become due during a debt limit stalemate.

In the end, I hope that reason will prevail and that the U.S. Government pays all its bills. If it defaults on Treasury obligations, then no other financial asset in the United States is safe.

I will still make sure that I have more money in F.D.I.C. insured accounts for when the climax appears to be approaching, perhaps as early as June.

Even when you're looking for safe places to store your cash, general investing rules apply: diversify your holdings and understand the level of risk that you are willing to take with your money.

Money market funds are a concern. They're not 100 percent secure. They are a blessing.