A Primer on Money Market Funds
Money market refers to a section of the fixed income market, where money needed in the near future (emergency fund, down payment for a home, cash in a brokerage account while waiting for stock/bond buying opportunities) can be parked for easy accessibility.
Unlike bonds, which are the well-known type among fixed income investment options, the money market deals with very short-term debt instruments such as those maturing in less than one year. Money market funds assure safety of principal since they are debt securities backed by governments, large corporations and banks. Due to their conservative nature, i.e., low-risk, money market funds offer lower returns than most other investments, sometimes almost nothing after costs.
Types of Money Market Funds
Unlike the stock market, money market instruments trade in high denominations, thereby restricting access for the retail investor. Similar to the forex market, the money market is dealer-oriented, where trading firms serve as the counter party and there is lack of a centralized exchange.
For the small-time investor, money market funds offer the chance to buy into these instruments. Such funds invest in short-term debt securities such as Treasury Bills (T-bills), commercial paper, and bankers’ acceptances, which are simply short-term loans to governments, banks and corporations.
It is prudent to buy money market funds without sales commissions as the low return coupled with such sales charges can cripple the investment into negative territory. Money market funds and their components such as T-bills, commercial paper, etc. are eligible for registered (RRSP and TFSA) and non-registered accounts. However, from a tax perspective, registered portfolios are better to avoid the interest being taxed at marginal rates.
T-bills offer the highest safety of principal since they are guaranteed by the Government of Canada; the Federal government would have to default on its debt obligation for the T-bill to lose its capital – an unlikely scenario. Canadian T-bills can be bought directly from any bank. They are sold at face value and earn interest when held to maturity (both the principal and interest are guaranteed by the Government of Canada); they are highly liquid and can also be sold at market value at any time. The terms of the T-bills can range from one month to one year and require a minimum investment amount of $5000 dollars.
Commercial paper is an unsecured, short-term (less than one year) promissory note issued by corporations to meet their debt obligations. It is not CDIC-insured and requires a large minimum investment ($100,000) as shown in this TD Money Market section.
As is the case with bonds, the longer the term of the money market fund, the higher the likelihood of interest rate risk. Low interest rate environments such as the current one mean that the money tied up in money market accounts would be earning a pittance, while denying the safety-seeking investor the chance to obtain better returns elsewhere. This opportunity cost is about the only risk with money market fund accounts.
7-day or indicated yield
Money market funds list their 7-day annualized yield, which is the amount earned by the fund, net of expenses, during the latest 7-day period. Compounding is not considered for the 7-day yield (similar to APR).
Effective or compound yield
The effective yield accounts for compounding through the reinvestment of interest and assumes that the fund will continue to generate this same (yield) amount on a weekly basis for the course of the year (similar to APY). This computation is based on the assumption that the interest rate will remain unchanged during the year; in case of a change in rate, the effective yield will show a directly proportional increase or decrease.
Do you invest in money market funds? Are they your stop-gap shop or are you stock-scarred to let them become your longer-than-needed safe haven?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.