Saturday, June 2, 2012

The Basics of Money Market Safety and Risk

In recent years, money market accounts have become popular alternatives to CD’s, short-term bonds, and classic savings accounts. In large part, this increase has been fueled by competitive yields, daily access to the money, and until recently, a sense of safety and stability. Many investors have discovered however, that even money market funds offered by the top banks and brokerage houses are not immune to a loss in value or liquidity.

While investors holding money market funds that have “broken the dollar” mark or become illiquid may be tempted to hunt down their broker or banker, they may not have much of a case. The reality is that most money market funds, though they seem very safe, are in fact mutual funds that can lose value just like any other mutual fund. This important fact, along with many others, is disclosed in accordance with SEC regulations in the prospectus that all investors are supposed to be delivered at or before the time of their initial purchase.

To help you keep your portfolio out of the red, here are some important facets every investor should understand about money market safety.

Mutual Fund Structure

True money market funds are not savings accounts but mutual funds. Instead of a bank loaning out your deposit and paying you part of the interest they earn, a money market fund actually uses your money to buy into a large pool of very short-term bonds. Depending on the type of money market fund, this pool of investments may include government bonds, corporate bonds, or municipal bonds.

Unlike most stock and bond mutual funds whose share price fluctuates, money market funds attempt to maintain a stable share price (also known as net asset value) of $1.00 per share. By keeping a stable share price of $1.00, investors get the sense that they can take out tomorrow what they put in today, with virtually no risk.

Money markets however, are not without risk. Since they ultimately represent a pool of assets owned by multiple investors, they are subject to a number of factors that could drive their share price below $1.00, creating a loss.

The largest factor that would likely contribute to a money market fund “breaking the dollar” barrier would be if enough of the assets in the underlying investment pool declined in value or became worthless. In other words, if the companies whose bonds the money market fund owns gets into financial trouble, those bonds will decline in value or become worthless. That in turn, causes each investor’s proportionate piece of the money market fund to also decline in value.

Another factor that might contribute to a loss in value is a rush on redemptions by the people invested in the money market fund. Since the majority of the money in a money market fund is invested in short-term bonds that mature at some point in the future, it’d create a major problem if a large number of investors wanted their money all at once.

Large simultaneous withdrawals could force a money market fund to sell some of its prior to their maturity date, which can also lead to a decline in the value. This can occur even in money market funds that only invest in U.S. Treasury securities, since the U.S. Treasury only backs securities held until maturity.

FDIC Insurance

Despite what many investors think, most money market funds are not FDIC insured. Even money markets that are offered through FDIC insured banks are not necessarily insured. Remember, a money market fund is a mutual fund that is subject to loss because of conditions in the investment market, just like any other stock or bond mutual fund. FDIC and SIPC insurance only cover accounts that are at risk because your banking or brokerage institution is going out of business. They do not protect you against poor investment choices or recommendations.

Some banks do offer FDIC insured money market accounts, but this is the exception more than the rule. To make sure your investments are covered, you need to ask your banker or broker specifically about FDIC insurance, as well as ask for a prospectus.

Doing Your Homework

The most important thing every money market fund investor should do visit one of the main mutual fund rating sites such as S&P or Fitch’s. If you’re looking for a safer place to park you cash assets, you should settle for nothing less than a top-rated money market fund.

Additionally, the SEC requires money market funds to regularly disclose a number of important facts, including their most recent list of holdings. Every investor should visit the corporate websites of money market funds they’re considering and review the funds’ most recent holdings. Be on guard for funds that own bonds from other companies or government agencies that have recently reported negative financial news.

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