Money Market Mutual Funds and Your Financial Plan
Intelligent cash management strategies preserve cash for meeting day-to-day expenses, maintaining an emergency fund, and also generating interest to help fund medium-term savings goals. For many, the money market mutual fund proves to be an ideal cash management solution.
Money market fund losses are extremely rare, but possible, and these investments will expose conservative savers to particular financial risks.
Money Market Deposit Accounts and FDIC Insurance
The money market mutual fund is not to be mistaken for the money market deposit account. As the naming would imply, money market deposit accounts are treated as bank deposits and money market mutual funds are treated as investments.
The Federal Deposit Insurance Corporation (FDIC) guarantees money market deposit accounts. FDIC insurance covers $250,000 per depositor, per banking institution. Wealthy savers will open multiple deposit accounts at multiple banks to maximize FDIC protection.
The FDIC, however, does not back money market mutual funds, or any other investment. For this, expect money market funds to pay out more interest than bank deposits, due to slightly elevated levels of risk.
Define The Money Market
Money market mutual funds are investment pools that purchase money market securities, while money market deposit accounts are not necessarily obligated to do so. Money market securities are short-term debt instruments, or loans, that mature in less than one year.
Money market securities would include treasury bills, commercial paper, certificates of deposit, bankers’ acceptances, and repurchase agreements. Institutions issue money market securities for working capital to finance day-to-day operating costs, such as payroll and office expenses. In exchange, investors collect relatively small interest payments upon these short-term loans.
The Federal Funds Rate
The federal funds rate is a market benchmark for all interest rates. United States banks post reserves at the Federal Reserve. Banks often times make overnight loans between themselves at the federal funds rate to satisfy their respective reserve requirements.
Now, for 2024, the Federal Reserve is targeting a 5.25% to 5.50% federal funds rate. Jerome Powell and The Fed have aggressively driven rates higher – to curb white hot inflation post COVID-19.
Going forward, the market expects The Fed to take a pause, before slashing rates again through the summer months. Lower interest rates ignite economic activity amid recession, by encouraging lending, capital spending, and investing.
Expect money market mutual fund rates to move in lockstep with the federal funds rate. Money market funds are also now paying out 5% in interest and have been exceptionally popular between 2023 and 2024. Money market mutual funds took in a record $123 billion in cash through the first week of 2024.
$1 NAV and Breaking the Buck
Money market mutual fund shares are to maintain a $1 net asset value (NAV). We calculate net asset value by dividing total mutual fund assets by shares outstanding. All money market mutual fund interest and capital gains are paid out as mutual fund dividends, which will be taxed as ordinary income.
Money market mutual funds will very rarely break the buck or fall below $1 per share. Breaking the buck typically signals that the fund is overleveraged through sudden spikes in interest rates.
The market might actually value a closed-end fund at a discount to net asset value through times of extreme volatility. Closed-end funds trade on organized exchanges, like individual stocks. In any event, money market mutual funds are known for safety of principal and the sanctity of $1 NAV.
Financial Strategies and Risks
Money market mutual funds and proper insurance coverage may combine as a backstop for emergency relief through untimely accidents and job losses. After establishing an emergency fund, conservative savers might add to their money market fund shares to finance future wedding, tuition, home down-payment, and real estate remodeling costs.
For example, a conservative saver may purchase money market fund shares to build savings towards a home down payment, real estate remodeling project, or wedding costs. Beyond these specific goals, money market mutual funds, alongside insurance coverage, can provide income in the event of untimely accidents and job losses.
Money market securities, again, offer relatively minimal interest payments because of their short durations and safety of principal. Expect money market funds to generate zero real growth, after subtracting out inflation.
A diversified portfolio featuring stocks will allow for potential growth. A middle manager salary man might have already retired as a millionaire, had he have redirected his money market mutual fund cash into Apple stock ten years ago.