Benign neglect has been a rational approach to managing cash since the financial crisis. It made little sense to apply any elbow grease searching for yields when options ranged from earning nothing to earning next to nothing.
But with last month’s rise in the Federal Reserve’s target interest rate and the expectation that there could be three rate increases this year, money market mutual funds are showing signs of life.
“We are heading to 1 per cent yields, and the bleeding edge of cash could touch 2 per cent in 2017,” said Peter Crane, the publisher of Money Fund Intelligence.
Modest, you say? Well, modest gains may be especially appealing given recent bond losses. In the fourth quarter, core bond funds, the go-to diversification tool for most investors, fell 3 per cent, as rising yields pushed down bond prices.
If you’re inclined to seek out even more stability in a money market mutual fund now that yields are resuscitating, make sure you understand recent changes in the rules that govern how some funds operate.
For decades, the value proposition of a money market mutual fund has been a steady price, or net asset value, that stays glued at $1. That stable price makes money markets highly liquid, because shares can be bought or sold for $1.
But in the September 2008 financial meltdown, an institutional money market fund could no longer maintain its $1 share price when Lehman Bros. declared bankruptcy and the fund was caught holding a large slug of Lehman’s short-term debt. That “breaking the buck” event set off worries of a possible run on other money market funds. The federal government stepped in with a guarantee that calmed the markets. And the Securities and Exchange Commission pushed through reforms that took effect in October that could make certain types of money market funds less appealing and less liquid.
Under the new rules, retail money market mutual funds sold to individuals will continue to offer a steady $1 net asset value, but the value of institutional money market funds will now float, based on current market prices. One potential problem is that during a period of extreme market anxiety, shareholders of some retail funds could find it more expensive to withdraw money or be temporarily barred from selling shares.
Some of the rules are quite technical: Retail money market mutual funds that invest in corporate debt (known as prime money market funds) and municipal money market funds are required to keep at least 30 per cent of their money in securities that can be easily sold within five business days. That should make it possible for a fund to absorb even an outsize run of redemption requests.
Even so, the SEC has also handed two new tools to the boards of prime and municipal money market funds: If that 30 per cent liquidity floor is breached, redemption fees of up to 2 per cent can be levied, and a fund may impose a “redemption gate” that restricts redemptions for up to 10 business days in any 90-day period.
Shareholders may find these fees and gates quite unappealing; the fund industry certainly does. It is afraid that the changes will scare off investors. That’s why most fund companies and brokerages have switched their default money market fund for retail clients from a prime fund to a government fund. Government funds invest in extremely liquid government debt, adding safety and liquidity, and these funds don’t have redemption fees or gates.
But government money market funds have a downside: lower yields. The largest retail money market fund, now called Fidelity Government Cash Reserves (it was a prime money market fund known as Fidelity Cash Reserves until the company changed the fund’s mandate), yielded just 0.13 per cent in early January.
While a money market fund still makes sense as a convenient parking lot when you sell an investment and aren’t ready to reinvest, online bank deals from the likes of Synchrony, Ally Bank and Capital One that currently yield at least 1 per cent may be better options for your permanent cash needs, such as an emergency fund.
And if you hold more cash than needed for emergencies, Ken Tumin of the account comparison site DepositAccounts.com recommends five-year certificates of deposit with lenient early withdrawal penalties. For example, if you deposit at least $25,000, the five-year CD offered by Ally Bank will pay you 1.75 per cent annual interest. If you want to cash out early, your maximum penalty is five months’ worth of interest. Tumin said it was “a bit irrational” to avoid long-term CDs for fear of losing out if rates move higher.
“It is unlikely they are going to skyrocket,” he said. “People worried about rising rates since 2008 have missed out on plenty.”
Short-term bond funds are another option for money you may need access to in the next few years, said Thomas Atteberry, co-manager of the FPA New Income bond fund. In the fourth quarter, short-term bond funds, which have an average duration of two years, lost half a percentage point compared with a 3 per cent loss for longer-term core bond funds, which have an average duration of five years. (Duration measures a portfolio’s sensitivity to rising rates: The longer the duration, the bigger the price losses when rates rise.)
“For money you might need in a few years, short-term gives you better yield than a money market with not as much price volatility as longer-term bonds, “ Atteberry said. FPA New Income posted a small positive return in the fourth quarter, and it gained 2.5 per cent for the full year.
Shorter-term bonds have become a better relative value. Warren Pierson, co-manager of the Baird Short-Term Bond fund, noted that in 2013, a 10-year Treasury bond yielded 2.65 percentage points more than a two-year Treasury. Today the gap is just 1.22 percentage points. “You aren’t giving up much yield to be more defensive now,” Pierson said.
Mary Ellen Stanek, also a manager of the Baird fund, said its shorter duration let the managers be comfortable with a bit more credit risk, enabling them to hold more of the better-yielding corporate bonds. “We see it as our all-weather bond fund,” she said. In the stormy fourth quarter, it lost 0.4 per cent, compared with a 3 per cent drop for intermediate-term core bond funds.
