Just How Safe Are Money Market Funds Really?

As the Fed has implemented its year-long policy of step-by-step increases in short-term interest rates, the yields on money market funds have risen in concert. Consequently, money market funds now yield more than most bank money market accounts. This is a return to the normal pattern, as explained last month. If your contingency fund is still residing at your local bank, you will very likely improve your returns by transferring your account to one of our recommended funds (see our Best Rates Tables ).

If experience is any guide, however, many people won't make the move. Why not? Many are simply uninformed—they don't know how easy it is to earn that extra yield by moving their account. But right behind that reason lies another: safety. Since money market funds are, after all, mutual funds, some savers just aren't convinced their money is safe.

That's right, money market funds are mutual funds. But they're a very specialized type of mutual fund. In a money market fund, the fund is run so that the value of each share stays constant at $1. For example, $1,000 will buy you exactly 1,000 shares at any money market fund, today, tomorrow, or next Thursday. It's this predictability that savers depend on to ensure they don't ever lose money, and it also makes it easy to determine the interest yield since you don't have fluctuating principal to figure into the equation. All gains translate directly into yield.

Fund companies will go to extraordinary measures to make sure they don't "break the buck"—meaning, let the value of these shares drop below that $1 constant price. For example, in 1994, unusual circumstances involving derivatives and Orange County California declaring bankruptcy caused a few dozen money market funds losses on investments they were holding. In each case, the parent companies of these funds stepped in and absorbed the losses so their shareholders wouldn't have to. To be fair, one institutional money fund did liquidate, causing losses of 6% for its institutional shareholders. But no individual investor has ever lost money in a money market fund.

Did these fund companies absorb the losses out of the goodness of their hearts? Hardly. The truth is, no fund company wants to be known as the first to break the buck. No fund has done it, and if it ever does happen, that company will be marked with a scarlet BB (buck breaker) forever. Little wonder then that these massive financial companies find it more palatable to swallow a one-time loss than live with this perpetual stain on their reputation.

Aside from the unofficial guarantee of the deep-pocketed parent companies, here are some other reasons money funds are a safe place for your savings:

• Short term holdings. Regulations require these funds to only invest in securities with maturities of less than 13 months. In addition, the average maturity of all the holdings in the fund can not be longer than 90 days. These ultra-short maturities assure that interest rate changes aren't going to drastically affect the funds. Rather, their yields will tend to move in lockstep with market interest rates, as we've seen these last several months as the Fed has raised rates.
• Regulations on investment quality. Money funds must limit their investments to securities rated high quality by a nationally recognized statistical rating organization. In addition, new regulations for money funds in 1995 cover derivatives and further define the boundaries for diversification and quality.
• Diversification. No money fund can invest more than 5% of its assets with a single issuer, unless that issuer is the government. So even a default by a particular issuer, as occurred in 1994, can have only a limited impact on any particular fund.

It's true, money market funds don't carry the same FDIC insurance that bank accounts receive. But given the stringent safety precautions in place to ensure that money market fund investors don't ever lose money, plus nearly 35 years of experience in which no individual has lost money, it seems that only the most risk averse saver is getting a fair tradeoff in lost interest yield for the tiny additional protection of FDIC insurance. Savers seeking additional peace of mind can stick with the most recognizable names in our Best Rates tables . While all money funds are safe, it's hard to imagine any circumstance that would cause Transamerica, Vanguard, Fidelity, or TIAA-CREF to break the buck.

Savings yields are still low, even with the Fed rate increases. There's no reason to push yours even lower by leaving your money in a bank account when higher yields are there for the taking in money market funds.

• Current Best Rates tables 
• Why You Usually Get Your Best Savings Deals from Money Funds
• Boost Your Returns Via an SMI-Recommended Money Fund
• Paying Yourself First
• Just What Does A Money Market Fund Own, Anyway? 
• SMI Savings Accounts page

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