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The fabulous yields, and lurking risks, of money market funds

The funds are paying enticing interest rates right now. But the debt ceiling and signs of weakness in the banking system are worrisome

The markets have been rocky ever since the Federal Reserve started raising interest rates to combat inflation last year.

Stocks and bonds have lost money. The costs of financing a car, a house or even a small credit-card purchase have risen. Two important regional US banks failed and needed bailouts, and worries about a possible recession have spread.

But it’s been a glorious time for one part of the financial world: money market mutual funds. The biggest money funds tracked by Crane Data are paying more than 4.6 per cent interest, and a handful have yields around 5 per cent.

Their gaudy interest rates closely follow the Fed funds rate, set by the central bank. The effective Fed funds rate is now about 4.83 per cent. That’s onerous for people who need to borrow money, and deliberately so: The Fed is raising rates because it is trying to squelch inflation by slowing the economy.

What’s painful for borrowers is great for people who need a place to park money they have put aside to pay the bills. In a bid to hold onto customers, some banks have begun raising rates in savings accounts and for certificates of deposit, though most bank deposits remain in accounts that pay close to nothing.

That’s given money market funds magnetic appeal. Their assets have swollen to more than $5.6 trillion, from $5.2 trillion in December 2021, when the Fed began talking about impending interest rate increases. Money market funds are likely to keep growing if the Fed holds rates at their current level, or raises them further.

I’ve used money market funds on and off for decades with no problems, and consider them to be fairly — though not entirely — safe. I think it’s reasonable to put some of your cash in them, as long as you are careful and keep your eyes wide open.

The landscape shifts

In June, when money market rates jumped from the near-zero level at which they had languished to as much as 0.7 per cent, I pointed out that for the first time in ages, it made sense to start shopping around for places to park your cash.

The days of being consigned to receiving nothing for the privilege of keeping your money in a financial institution were over, if you were willing to make a move. When interest rates started to rise, money market rates started levitating immediately, opening up a wide gap with bank deposit rates.

By now, that gap has widened to its greatest level in decades. The advantages of money market funds are increasingly obvious, not just for the corporate financial officers who have always used them as an efficient and high-yielding place to hold money, but for thousands of ordinary people, who are at last receiving something for their cash.

Say you’ve got $10,000 to stash somewhere. Keep it in a checking account, and you will receive nothing, or close to it. Keep it in a money-market fund paying 5 per cent for a year and you will receive $500.

That won’t make you rich. Depending on consumer prices, you could lose purchasing power in inflation-adjusted terms. Right now, money market yields are just beginning to approach the annual rate of the Consumer Price Index, which was 5% in March. But compared with nothing, $500 is wonderful.

Some banks are beginning to offer competitive rates with insurance from the Federal Deposit Insurance Corp. — Apple, for example, has partnered with Goldman Sachs, and is marketing a 4.15 per cent interest account. Many other financial institutions are competing for attention, too, but they generally lag money market rates.

In short, if you are a money-market fund investor, rising interest rates can be delightful. But, as always in finance, a benefit is rarely without cost.

Known vulnerabilities

Investors have never had major losses in money market funds in the US, and I find that record comforting.

But it doesn’t mean that the funds are without risk.

For one thing, there are already indications that their growing popularity comes partly at the expense of banks, especially smaller ones that have lost deposits. Such losses — which contributed to the collapses of Silicon Valley Bank and Signature Bank last month — have created stress in the entire financial system.

More than $560 billion in deposits exited the commercial banking system this year through April 5, according to government figures. At the same time, more than $442 billion flowed into money market funds, according to Crane Data. That’s been great for the income of the fund investors, but it’s not an unalloyed good for financial institutions.

You can see this in individual companies. At Charles Schwab, for example, which has just reported its quarterly earnings, the firm’s banking arm lost $41 billion in deposits in the first three months of the year. At the same time, Schwab’s money market funds gained $80 billion.

For Schwab customers, the shift has been a tremendous boon. It means a big surge in income for them. For the company’s shareholders, though, it means a crimp in profits. As a company, Schwab says, it is strong enough to handle the shift. That may be so, but not all financial institutions are in solid shape right now.

Financial regulators are monitoring these issues closely.

Money market ‘runs’

It’s not just banks that are vulnerable to “runs” — panics, in which people scramble to withdraw their money, spurring others to do the same, in a vicious cycle. Money market funds are periodically subject to runs, too.

There have been only two known incidents in which money market funds were unable to pay 100 cents on each dollar invested in them — they “broke the buck,” in Wall Street jargon — and, despite headaches and long payment delays, no significant losses occurred in those cases.

But there have been many near misses. A 2012 report by the Federal Reserve Bank of Boston found more than 200 instances in which companies that ran money market funds quietly poured money into them to ensure that the funds could pay investors 100 per cent of the money they expected.

Recall that the Fed had to restore calm during money market runs in 2008 and again in 2020, during a brief crisis at the start of the coronavirus pandemic. The Securities and Exchange Commission, which regulates money market funds, has already tightened its rules twice, and it is proposing additional changes.

How to use them

These days, I have a variety of places to stash the cash I’ll need to pay the bills.

These include accounts at a major global commercial bank, a credit union, an online high yield FDIC-insured savings bank and a low-fee money-market fund with a large, reputable asset management company. Over the past year or two, I’ve kept some money in all of these, though the money market fund has become my favourite lately, because it generates steady cash.

But when the Fed drives interest rates back down — that could happen soon if there’s a recession, or many months from now, if inflation is persistent — money-market fund rates will drop, too, and I’ll reduce my holdings in them.

I’m also aware of the potential perils associated with money market funds. To minimize risk, I use a so-called government fund — one that holds only Treasury bills, other securities of the US government and of US agencies, and reverse repo securities at the Fed. That eliminates the possibility that my fund will hold securities issued by a private company that goes belly up — as Lehman Brothers did in 2008, causing trouble for some money market funds.

Of course, Treasury bills aren’t 100 per cent safe either, not with the federal debt ceiling looming. Mind-boggling as this may be, it is possible that the US government could default on its debt. Many money market funds are avoiding Treasury bills that could come due during a debt ceiling stalemate.

This article originally appeared in The New York Times