Money Market Funds: Where Are Your Investments Going?

Money market funds are a type of mutual fund that invests in short-term, higher-quality, and highly liquid securities. These funds are designed to provide high liquidity with lower risk, capital stability, and typically higher yields than some other cash products. Money market funds can be divided into three general categories: government money market funds, municipal money market funds, and prime money market funds. Government money market funds are limited to government securities, such as U.S. Treasuries and collateralized repurchase agreements involving Treasuries. Municipal money market funds, also known as tax-exempt funds, invest in municipal securities, which are typically exempt from federal income tax. Prime money market funds, also called general-purpose money market funds, can invest in any of the security types mentioned above.

Where Are Money Market Funds Invested?

US Treasuries

US Treasury money market funds pool money from investors to purchase US government debt, such as Treasury bills, and repurchase agreements. These funds are regulated by the Securities and Exchange Commission (SEC), which sets rules regarding the maturity, credit quality, and liquidity of the securities. The SEC's Rule 2a-7 of the Investment Company Act of 1940 stipulates that money market funds can only invest in the highest-rated debt, with a maturity period of under 13 months, and a weighted average maturity (WAM) of 60 days or less.

US Treasury money market funds aim to maintain a net asset value (NAV) of $1 per share. They are popular among investors seeking stable, low-risk investments that preserve their principal. These funds are also suitable for those with short-term investment goals or those looking to temporarily park their money before investing elsewhere.

Some popular US Treasury money market funds include:

• Vanguard Treasury Money Market Fund (VUSXX)
• Fidelity Treasury Only Money Market Fund (FDLXX)
• American Century Capital Preservation Fund (CPFXX)

Municipal Securities

Municipal money market funds are appropriate for investors who have a low tolerance for volatility and are looking for a conservative investment option. These funds are also suitable for those who require a highly liquid investment and have a short-term investment horizon.

Municipal money market funds typically invest at least 80% of their assets in municipal securities, with interest income that is exempt from federal income tax. In some cases, the interest earned may also be exempt from state income taxes. This feature makes municipal money market funds attractive for non-retirement accounts that are not already tax-shielded.

The interest income generated by municipal money market funds can be either taxable or tax-exempt, depending on the specific securities held by the fund. These funds aim to maintain a stable net asset value (NAV) of $1 per share, providing regular income for investors.

Overall, municipal money market funds offer investors a low-risk, low-return investment option with the benefit of potential tax advantages.

Commercial Paper

Money market funds, which are mutual funds that invest in short-term, high-quality, and low-risk securities, commonly invest in commercial paper due to its short maturity and relatively low risk. These funds aim to maintain liquidity while generating modest returns, making commercial paper a suitable investment option for their investment strategies.

In summary, commercial paper is an important component of money market funds, providing a source of funding for large corporations while offering a diversification opportunity for investors seeking low-risk and liquid investment options.

Repurchase Agreements

Money market funds (MMFs) use repos to invest surplus funds on a short-term basis. The rates for repos are negotiated based on market conditions, supply and demand for collateral, and the credit quality of the underlying securities. There are two types of securities used in repo agreements: traditional, which include US government securities such as US Treasuries and agency debt; and non-traditional, which include non-government securities such as corporate investment-grade debt and equity securities.

The repo market is one of the largest and most actively traded sectors in the short-term credit markets and is an important source of liquidity for MMFs. The US Federal Reserve also plays a key role in this market by engaging in open market operations to regulate the money supply and bank reserves, helping to keep the federal funds rate within the target range.

Bankers' Acceptances

Here's how BAs work:

• The importer obtains a BA from their bank, similar to applying for a short-term loan with credit checks and underwriting processes.
• The bank charges a fee and issues a time draft, guaranteeing future payment to the exporter.
• Upon the bank's acceptance, the liability transfers from the importer to the bank.
• The exporter can choose to keep the BA until maturity or sell it to a third party, often at a discounted price, without having to wait for the funds.
• The bank can then hold the BA until maturity or rediscount it by selling it on the secondary market.

BAs are considered safe and liquid investments, especially when the paying bank has a strong credit rating. They are traded in a liquid secondary market and are similar to other money market instruments like Treasury bills. The maturity of BAs is usually between 30 and 180 days, and they provide modest profits with yields above those of T-bills.

Frequently asked questions