Yields soar on tax-free money market mutual funds

The recent run on money market mutual funds has had the temporary side effect of sending yields soaring on tax-free municipal money market funds. As of Oct. 1, the Vanguard Tax-Exempt Money Market Fund (VMSXX) was paying 5.83 percent. For someone in the 28 percent tax bracket, that would be the equivalent of earning 8.1 percent.

This isn’t due to a decline in the quality of the short-term municipal bonds these funds hold. It's a result of the mass redemptions in money market funds that took place when worries arose about their safety. (Not to be confused with bank money market accounts—which are FDIC insured—money market mutual funds are not insured but are regulated to invest in short-term, generally safe securities.) Short-term municipal bonds are safer than the Lehman Brothers bonds that got a taxable money fund into trouble. But the industry-wide redemptions forced the financial firms that market short-term municipal securities for state and local governments to offer them at higher yields to create greater demand for them.

However, these high rates aren’t expected to last. Matt Fabian, the managing director at Municipal Market Advisors, a muni bond research firm, expects these rates to subside after a month or so, but remain above average for this year.

Greg McBride, senior financial analyst at Bankrate.com, agrees and says that you should be prepared to move your money elsewhere, such as a high-yield savings account, when yields return to earth. He notes that any new money put into these types of funds won’t be covered under the U.S. Treasury guarantee program, a plan recently introduced to insure money market fund share prices.

For this reason, if you put money into a tax-free money market fund, it’s advisable to stick with one of the larger fund companies, like Fidelity, T. Rowe Price, or Vanguard. “Fund management has become much more difficult in the turmoil, and a larger pool of invested assets gives the fund manager more flexibility that he or she can use to protect the money market investor,” Fabian says. State-specific tax-free money market funds may make sense if you pay state tax. —Chris Fichera

Comments

[Jerry in LA]

oh, this is the information I've been looking for. I thought that all the short-term municipal debt instruments had turned into junk bonds overnight!

[Andy]

I just moved my funds to the Vanguard Money Market Tax Free fund. It is really an amazing rate being offered. I wrote a post recently on this topic and other money saving tips as well, but the key point to remember is to check the Expense ratio of these funds. Some money market funds are paying upto 6%, but have high expense/management ratios. Vanguard and Fidelity have amongst the lowest in the market.

[Sonny]

Jerry you are right on...I was like how can they be yielding 8.8 percent after adjusting for taxes.

[Kolya]

...
This isn’t due to a decline in the quality of the short-term municipal bonds these funds hold.
...

Remember what happened to the auction rate security market? I had two friends whose money was tied up for months. I submit that there may be many markets / securities that performed well under normal conditions that may not perform as well in the current crisis.

Apparently some of the short term municipal securities function in a very similar way to the auction rate securities - i.e. they depend on the willingness of wall street entities (banks etc) to provide liquidity. Thankfully interest rates on these securities can be increased to draw in buyers that would not normally participate in these markets. This explains the higher rates.

All the above said I recently transferred 80% of my money market cash from a treasury MM fund into a CA MM fund.

I worry though about municipalities whose ability to service their short term debts depends on them issuing more debt - in that situation things could get sticky indeed - suppose other investors are not willing to buy the new debt? We should be humble about what we think we understand about markets.