Money-Market Funds May not Be As Safe As You Think

Yesterday, another piece of big news was that The Reserve Primary Fund (RFIXX) announced it cut the money-market fund’s net asset value (NAV) to 97 cents from $1.00, a news that surprised and shocked many, especially those invest in the fund (CNBC). The reason the fund decided to reduce the NAV by 3 cents, also known as “break the buck”, is that RFIXX has suffered massive redemption lately, losing $43 billion in assets since August 31. Today, another money-market fund, the institutional Putnam Prime Money Market Fund, is shutting down because of a surge in redemption (WSJ).

Why is this a big deal?

Because money-market funds, one of the most conservative investments, are supposed to be rock-solid safe and liquid, as good as cash. If I put $1 in the fund, but only get 97 cent back, of course it’s a big deal. The whole reason for investing in money-market fund is to not lose money. If I want to receive bigger rewards, I would have to put my money in riskier investments such as stocks or a mutual fund (though money-market funds are mutual funds). The money-market funds, on the other hand, are for safety, which is determined by what the funds can invest. According to SEC, money-market funds are required by law “to invest in low-risk securities.”

Money market funds typically invest in government securities, certificates of deposits, commercial paper of companies, and other highly liquid and low-risk securities. They attempt to keep their net asset value (NAV) at a constant $1.00 per share — only the yield goes up and down. But a money market’s per share NAV may fall below $1.00 if the investments perform poorly.

But low-risk comes with different kinds of flavors. Among those investment options mentioned above, there truly low-risk investments, such as government securities and there are investments carrying a relative larger degree of risk, such as commercial paper. When looking carefully into the funds’ holdings, you will find that different money-market funds have different investments with different risk levels. For example, the Reserve Primary Fund has the following investments in the fund as of May 31, 2008 (fund annual report, PDF file):

• Commercial Paper: 53.9%
• Negotiable Bank Certificates of Deposit: 16.4%
• Floating Rate Notes: 14.9%
• Repurchase Agreements: 9.0%
• Euro Time Deposit: 2.2%
• Medium-Term Notes: 1.1%
• US Agency Bonds: 0.8%
• Promissory Notes: 0.8%
• US Corporate Notes/Bonds: 0.7%

The largest investment RFIXX has is commercial paper (more than half of its assets), of which $535 million is issued by Lehman Brothers. The true safe heaven, US government bonds, is less than 1% in the fund’s total assets.

Now, let’s look at another example, Vanguard Primary Money Market Fund (VMMXX). As of February 29, 2008, the fund has:

• US Government and Agency Obligations: 45.2%
• Certificates of Deposit: 26.9%
• Commercial Paper: 12.5%
• Eurodollar Certificates of Deposit: 10.6%
• Repurchase Agreements: 3.1%

It’s quite clear that the two funds are taking two opposite approaches in seeking low-risk investments with Vanguard emphasizing on government securities.

In the past when the market was calm, those commercial paper issued by companies like Lehman Brothers could indeed be a low-risk, safe investment. But now, after what happened on the Wall Street recently, it’s a entirely different game. Actually, the fact that investors are now pulling their money out of money-market funds also underscores how nervous people have become about their savings. The safety of our money is the most important thing right now.

And always read the prospectus before investing in a fund, even it’s a money-market fund

BTW, check out what others have to see on this latest development:

• Money Market Fund Breaks The Buck: What’s Safe Now?? at My Money Blog
• Even Money Market Funds Have Downside Risk at My Wealth Builder

*Photo from nielsimons.nl

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