Money markets

From Bogleheads

Money markets are a collection of short-term investment instruments that are highly liquid and easily converted into ready cash. Because they are short-term, money market instruments rapidly adjust to changes in short term interest rates.

Investors hold cash investments for a number of reasons, for example as an emergency fund, or for payments 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 has a fixed term, and is less liquid than a deposit account because withdrawing principal early often has a penalty.

You can buy small denomination CDs 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 sensibly stay within these limits.[1] The standard insurance amount is $250,000 per depositor, per insured bank, for each account ownership category.

Cash also includes some liquid securities bought and sold on the money markets. These include treasury bills, institutional large bank CDs, commercial paper, bankers acceptances, and repurchase agreements (repos). Tax-exempt money market funds hold short term municipal securities.

Marketable money market instruments

The main money market instruments are:

  • 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). They are sold at auction at a discount, and the bill matures at par, the difference being the interest earned. Interest you earn on T-bills is exempt from state income tax, giving a tax benefit. T-bills are the only institutional marketable money market instrument that you can directly purchase. You can purchase them at auction through brokerages and banks, or through an individual account at Treasury Direct. Federal agencies also issue short term instruments. Some of these have the full faith and credit backing of the treasury, but 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. The New York branches of foreign banks issue Yankee CDs. Eurodollar CDs are dollar denominated CDs issued by foreign banks. As well as credit risk, Yankee and Eurodollar CDs bear sovereign risk; that is, the chance that a government might confiscate or freeze assets.
  • Commercial Paper: An unsecured, short-term debt instrument issued by a corporation, typically for financing accounts receivable, inventories, and meeting short-term liabilities. Maturities on commercial paper rarely range any longer than 270 days. Corporations usually issue the debt at a discount, reflecting prevailing market interest rates. S&P and Moodys rate commercial paper. For more, see: Commercial paper from Wikipedia.
  • 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. They trade at a discount from face value on the secondary market, and have a long history. For more, see: Banker's acceptance from Wikipedia.
  • 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. For more, see: Repurchase agreement from Wikipedia.
  • 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. They 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.

Money market funds

Money Market funds are mutual funds that invest in money market instruments. By design, they are meant to maintain stable Net asset value (NAV) of $1.00 per share, and provide investors with interest dividends. Money funds give you convenience, diversification of risk, and competitive short term yields (although the costs of investment are a critical factor in accessing the money market through funds). The underlying investments in the portfolio characterize money market funds. This specialization allows funds to differentiate by risk and tax characteristics.

Money market funds include:

  • General Money Funds: These invest in a selection of money fund instruments: treasury bills, CDs, Yankee CDs, Eurodollar CDs, Commercial Paper, and Banker's Acceptances. They are usually heavily weighted towards the non-treasury instruments. Because they are exposed to credit risks, they have higher interest coupons than treasuries (you can think of this excess interest as the default risk premium). The non-treasury component of a General Money Market Fund is taxable income for both federal and state tax.
  • Treasury Money Funds: Treasury money funds invest 100% in "full faith and credit" treasury bills and agency instruments. As a result they are not subject to credit risk (because 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 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 so generate interest for state residents that is exempt from federal tax, state tax, and sometimes local tax. Tax exempt funds are subject to credit risk, as well as the risk of tax law change to their exemption status.

Money fund regulation

Rule 2a-7[2] of the Investment Company Act of 1940 regulates money funds. Key regulation provisions 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: Apart from 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.[2]

Under the 2014 final rules,[3] 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 summary:

  • 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 its 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

Although money-market funds are low risk, they are not zero-risk. If 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.

Since their introduction 1971, money market funds have broken the buck on only two occasions.[4] Most notably, in September 2008 three money-market funds of The Reserve broke the buck after Lehman went bankrupt.

A fund files the monthly market price value ("shadow price") of money market funds, along with copious amounts of other information on fund holdings, with the SEC on form N-MFP. The table below has links to these reports for Vanguard's low-cost money market funds.

Fund Form
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

Default risk premium

Default risk premium refers to the additional return from 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.

As a result, 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.

Default risk premium (October 2015)
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%
Default Premium -0.01% -0.01% -0.01% -0.11%

These comparisons also do not take into account the tax advantage of the treasury fund's exemption from state tax. If you hold General Money Market Funds you need to keep control of costs if you want to gain any of the default risk premium. The Vanguard Prime Money Market Fund has had the following default premium yields over the Vanguard Admiral Treasury Fund, although taxable investor need to reduce the premium to account for any state.

Vanguard Prime MMF default risk premium (October 2015)
Fund 1 year 3 years 5 years 10 years
Vanguard Prime MMF 0.02% 0.01% 0.03% 0.16%

After-tax yields

If you are comfortable bearing default risk, you can choose a money market return using the fund's after-tax return. The calculator below (courtesy of the The Financial Buff blog) analyzes money funds, taking into account all taxable input federal, state, and alternative minimum tax.

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.


  1. "Understanding Deposit Insurance". FDIC. July 30, 2020. Retrieved August 26, 2023.
  2. 2.0 2.1 "17 CFR § 270.2a-7 - Money market funds". Legal Information Institute. Retrieved August 26, 2023.
  3. "Federal Register :: Money Market Fund Reform; Amendments to Form PF". Federal Register. August 14, 2014. Retrieved August 26, 2023.
  4. "Vanguard's Nafis Smith on the enduring advantage of low-fee money market funds". Vanguard. 2023-04-05. Retrieved 2023-08-28.

External links

Further reading