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In the investment world, we speak of cash as a collection of short-term investment instruments that are highly liquid and easily converted into ready cash. These investments make up the money markets. The short-term nature of all money market instruments means that they rapidly adjust to changes in short term interest rates. Cash investments are held by investors for a number of reasons, primarily as liquid emergency reserves and for funding obligations due in the short to intermediate term. Cash includes familiar bank instruments such as transaction and savings accounts, as well as short term bank certificates of deposit (CDs). A certificate of deposit is issued for a fixed term and is less liquid than deposit accounts since an early withdrawal of principal often incurs an early withdrawal penalty. Small denomination CDs can be purchased directly from banks or from a brokerage. Cash held in any bank instrument is subject to credit risk in the case of bank failure. Bank deposits are generally insured up to $250,000 by the FDIC and most depositors prudently stay within these limits.[note 1]
Cash also includes a number of marketable liquid securities bought and sold on the money markets. These securities include treasury bills, institutional large bank CDs, commercial paper, bankers acceptances, and repos. Short term municipal securities are held by tax-exempt money funds.
Marketable money market instruments
- Treasury Bills: Obligations backed by the full faith and credit of the U.S. government with a maturity of less than one year. T-bills are sold in denominations of $1,000 up to a maximum purchase of $5 million and commonly have maturities of one month (four weeks), three months (13 weeks) or six months (26 weeks). T-bills are sold at auction at a discount; the bill matures at par, the difference being the interest earned. T bills possess a tax benefit in that the interest earned is exempt from state income tax. T-bills are the only institutional marketable money market instrument that can be directly purchased by individual investors. T-bills can be purchased at auction through brokerages and banks as well as through an individual account at Treasury Direct. Federal agencies also issue short term instruments. Some of these instruments have the full faith and credit backing of the treasury; others do not.
- Bank Certificates of Deposit: Market CDs are large, often multi-million dollar CDs offered by commercial banks and sold to large institutional investors. Yankee CDs are issued by the New York branches of foreign banks; Eurodollar CDs are dollar denominated CDs issued by foreign banks. In addition to credit risk, Yankee and Eurodollar CDs bear sovereign risk, the chance that a government might confiscate or freeze assets.
- Commercial Paper: An unsecured, short-term debt instrument issued by a corporation, typically for the financing of accounts receivable, inventories and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. The debt is usually issued at a discount, reflecting prevailing market interest rates. Commercial paper is rated by S&P and Moodys. For details on commercial paper refer to this entry.
- Banker's Acceptances : A short-term credit investment created by a non-financial firm and guaranteed by a bank, often in connection with foreign trade. Acceptances are traded at a discount from face value on the secondary market. Bankers acceptances have a long history.
- Repos: Repurchase agreements (Repos) are made when a borrower deposits a treasury bill or other security as collateral with a lender who extends an overnight loan to the borrower. The difference in repurchase price determines the interest rate of the overnight loan. See this entry for details.
- Municipal Securities: Include a variety of short term municipal issuer short term instruments. These include general market notes, commercial paper, put bonds, and variable rate demand obligations (VRDOs). VRDOs comprise a significant percentage of the outstanding debt in the short term municipal market. VRDOs can be structured to provide a wide range of maturity options (1 day to over 360 days) to the underlying issuing entity and are typically issued at par. Municipal securities are exempt from federal taxation, although some private revenue securities are subject to the federal alternative minimum tax.
The money market fund
Money Market funds are mutual funds that invest in money market instruments. By design, they are meant to maintain stable net asset valuations of 1.00 per share and provide investors with interest dividends. Money funds provide convenience, diversification of risk, and competitive short term yields (although, as we will see, the costs of investment are a critical factor in accessing the money market through funds). Money funds are characterized by the underlying investments comprising the portfolio. This specialization allows for funds to be differentiated by risk and tax characteristics. Money funds include:
- General Money Funds: These funds invest in a large gamut of money fund instruments: treasury bills, CDs, Yankee CDs, Eurodollar CDs, Commercial Paper, and Banker's Acceptances. These funds are usually heavily weighted towards the non-treasury instruments. Since these instruments are exposed to credit risks, they provide higher interest coupons than treasuries (this excess interest can be called the default risk premium). The non-treasury component of a General Money Market Fund is taxable income for both federal and state jurisdictions.
- Treasury Money Funds: Treasury money funds invest 100% in "full faith and credit" treasury bills and agency instruments. Thus they are not subject to credit risk (since the treasury has monopoly power to print fiat currency.) Treasury interest is exempt from state income taxation. Government funds include treasury securities along with other government agency paper not backed by the "full faith and credit" guarantee.
- Tax Exempt Funds: These funds invest in municipal money market instruments. The interest is generally exempt from federal taxation (although some interest may be subject to the alternative minimum tax.) State Specific Tax Exempt Funds invest in municipal securities of an individual state and thus provide federal, state, and sometimes local tax exempt interest for state residents. Tax exempt funds are subject to credit risk as well as the risk of tax law change to their exemption status.
Money fund regulation
Money Funds are regulated under Rule 2a-7 of the 1940 Investment Company Act. Key provisions of the regulations require the following:
- Maturity: Money funds can only invest in money market instruments maturing under 12 months and must maintain a weighted average maturity of 60 days or less.
- Diversification: With the exception of federal government securities, money funds may not invest more than 5 percent of their assets in a single issuer.
- Credit Quality: Money funds must limit their investments to securities that are rated in one of the two highest short-term rating categories by a nationally recognized statistical rating organization (NRSRO). Investment in second-tier securities is limited to 3% of total fund assets, with a limit of 0.5% for any single issuer. Investment in second tier securities is restricted to maturities of 45 days or less.
Under the 2014 final rules, money funds are divided into three classes: institutional, retail, and government. Institutional money funds must have a floating NAV based on market values. The rules also provide for liquidity (redemption) fees and gates (suspended redemption) during periods of market distress. In summation:
- A fund may impose a fee of up to 2% on redemptions if a fund's weekly liquid assets fall below 30% of its total assets.
- A fund must impose a 1% fee on redemptions (with the option of imposing a fee of up to 2%) if a fund's weekly liquid assets fall below 10% of its total assets—unless the fund's board determines a fee would not be in the fund's best interest.
- A fund may impose a gate—that is, suspend redemptions—for up to 10 business days in a 90-day period.
- The fees and gates rules only apply to retail and institutional funds, although government funds may voluntarily adopt them if the fees and gates are previously disclosed to investors.
Breaking the buck
While money-market funds are low risk, they are not zero-risk. In the event that some of the underlying investments default, the fund may not be able to maintain a net asset value of $1.00/share; this failure is colloquially known as breaking the buck.
As of November, 2009, there have been only a few cases when this has actually happened. Most notably, three money-market funds of The Reserve broke the buck in September, 2008, after Lehman went bankrupt.
The monthly market price value ("shadow price") of money market funds, along with copious amounts of other information on fund holdings, are filed with the SEC on form N-MFP. The table provides links to these reports for Vanguard's low-cost money market funds.
|Admiral Treasury Money Market||Forms N-MFP|
|California Tax-Exempt Money Market||Forms: N-MFP|
|Federal Money Market||Forms: N-MFP|
|New Jersey Tax-Exempt Money Market||Forms: N-MFP|
|New York Tax-Exempt Money Market||Forms: N-MFP|
|Ohio Tax-Exempt Money Market||Forms: N-MFP|
|Pennsylvania Tax-Exempt Money Market||Forms: N-MFP|
|Prime Money Market||Forms: N-MFP|
|Tax-Exempt Money Market||Forms: N-MFP|
The default risk premium
The default risk premium refers to the additional return gained by investing in securities with a risk of default, where treasuries and other securities backed by the full faith and credit of the US government are considered to have no default risk. If there were no default premium, then investors would have no incentive to invest in anything but treasuries. Investment costs have a direct impact on how much of the default risk premium a money market fund investor can earn. Indeed, the high costs of the average money fund totally consume the default risk premium. Thus, investors are often exposed to 100% credit default risk without receiving any compensation over the default free treasury bill. The following table compares the multi-period yields of the average money market mutual fund with the low cost (currently closed to new investors) Vanguard Admiral Treasury Money Market Fund.
|Fund||1 year||3 years||5 years||10 years|
|General Money Market Fund||0.00%||0.00%||0.00%||1.13%|
|Vanguard Admiral Treasury Fund||0.01%||0.01%||0.01%||1.24%|
These comparisons also do not take into account the tax advantage of the treasury fund's exemption from state tax. Thus, investors in General Money Market Funds must keep control of costs if they wish to garner any of the default risk premium. The Vanguard Prime Money Market Fund has provided the following default premium yields over the Vanguard Admiral Treasury Fund, although the premium must be reduced by an individual's state tax rate for taxable investors.
|Fund||1 year||3 years||5 years||10 years|
|Vanguard Prime MMF||0.02%||0.01%||0.03%||0.16%|
Assuming that a money market fund investor is comfortable bearing default risk, the selection of a money market fund can be determined by the after-tax returns of the fund. The calculator below (courtesy of the The Financial Buff blog) takes into account all taxable input federal, state, and alternative minimum tax for money fund after-tax return analysis.
Income Tax Rates are available from the following sources:
The fund provider can give you the percentage of a tax-exempt money fund's assets held in securities subject to the alternative minimum tax. Information from Vanguard can be attained at the Vanguard web site:
- Understanding Deposit Insurance. The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.
- Wikipedia Cash and cash equivalents
- Wikipedia Treasury bills
- Wikipedia Certificate of deposit
- Wikipedia Commercial paper
- Wikipedia Bankers acceptances
- Wikipedia Repurchase agreements
- Variable Rate Demand ObligationsStandish Mellon
- Rule 2a-7
- SEC Final rules
- Vanguard fund data 2/28/2009
- Vanguard fund data 2/28/2009
- The Money Market, tutorial by Investopedia.
Money Fund information providers
- ICI Report of the Money Market Working Group March 17, 2009
- ICI Pricing of U.S. Money Market Funds January, 2011