Of Mutual Interest

Money fund rules don’t leave wiggle room

By Mark Jewell
Associated Press / June 13, 2010

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Money market mutual funds are safe places to stash cash and see it slowly but steadily grow. Except for one recent misstep, it’s been that way for four decades.

Now, the industry is playing by new rules to make amends for that one false move. It’s all about restoring confidence in money funds’ biggest selling points: the near-certainty that investors won’t lose money and that they can quickly pull cash out even when markets are in turmoil.

The problem is, the tighter rules are shaving a bit off money funds’ historically small returns. These days, that’s not much.

Yields for the bulk of the $2.8 trillion stashed in money funds have hovered barely above zero since early last year. Yields normally ranging from 2 to 4 percent now average 0.04 percent — four bucks a year for each $10,000 invested — making currently tiny rates for bank accounts look good.

Blame goes in part to the Federal Reserve, which is keeping short-term interest rates at next to nothing to get the economy back on track. That’s left money fund managers little room to squeeze more yield by venturing into slightly riskier investments than their peers are buying. Money funds are restricted to buying the safest types of debt, such as Treasuries or short-term corporate bonds from high-quality issuers.

That wiggle room is getting even narrower because of rules the Securities and Exchange Commission is phasing in this year. The goal: ensuring money funds are true safe havens on the rare occasion when stocks, bonds, and almost everything else are tanking.

That’s what happened in September 2008, when Lehman Brothers collapsed. The bank’s demise also took down a large money fund whose investment in Lehman bonds blew up. The Reserve Primary Fund was unable to give fleeing investors a dollar back for each buck they had put in. It was the first time individual money fund investors suffered losses since Reserve Primary launched the industry in 1971. At latest count, the collapsed fund’s investors have received $50.5 billion, or 98.6 percent of the fund’s assets when it “broke the buck.’’

Still, it was a headache for investors who couldn’t access their cash while the fund was shutting down. Investors often use money funds while they’re waiting to move back into stocks, or to make a down payment on a home. Many firms also keep clients’ uninvested brokerage account balances in money funds.

Here’s a look at the rules the SEC approved in February, and the investor impact:

■ Higher Credit Quality: For the past two weeks, money funds have been barred from investing more than 3 percent of their assets in securities that are other than the highest grade. That should reduce the chance of a fund blowing up from overly speculative investments. Previously, funds were allowed as much as 5 percent of “second-tier’’ securities carrying slightly higher risks and returns.

Also, funds can hold no more than 0.5 percent of their portfolios in second-tier debt from a single issuer. The goal: preventing one soured investment from tripping up an entire portfolio.

■ Cash on Demand: Reserve Primary broke the buck as investors tried to pull out en masse. One reason the fund couldn’t meet redemption orders: Too many holdings were in bonds that matured in weeks or months rather than days. Now, taxable money funds must hold at least 10 percent in cash, Treasury bonds, or other securities that can be sold for cash within a day. In addition, at least 30 percent must be convertible to cash within a week.

■ Shorter Bond Maturities: Starting June 30, the average maturity of bonds money funds buy must be shortened to no more than 60 days from the previous 90 days. That could hurt yields because longer-term debt offers greater returns due to its higher risk.

■ Transparency: On Oct. 7, funds must start providing additional disclosure, including publishing their portfolio holdings on their websites every month.

Most managers have been running their funds more conservatively in anticipation of the new rules. But now that those rules are taking effect, it may be harder for fund managers to outperform their peers.

“In the current interest rate environment, there’s certainly less reward for stretching to increase yield,’’ said Connie Bugbee, managing editor of money fund researcher iMoneyNet.

It’s already been happening, because of the narrower opportunities money fund managers have with rates so low.

The difference between the top-yielding money fund and the 10th highest tracked by iMoneyNet is tiny: 0.21 percent to 0.08 percent, as of June 1. That means, on a $10,000 investment, the highest-yielding fund among the Top 10 would earn just $13 more per year than the lowest.

Bugbee doesn’t expect yields to inch up from their current record lows as long as the Fed keeps its bank lending rate between zero and 0.25 percent.

Peter Crane, of the fund researcher Crane Data, is a bit more optimistic. He notes that investor withdrawals from money funds eased in May as worries about Europe’s debt troubles led them to seek protection. Investors are also nervous about the government’s removal of measures to lift the US economy out of recession.

Those worries have left investors more nervous about risk, and demanding higher returns on many types of debt. That means companies and governments that raise cash by selling bonds to money funds have to pay higher rates.

But with the new rules kicking in, expect any further gains in money fund yields to be restrained because of the demand for greater safety.

“We’re years away from measuring returns in full percentage points,’’ Crane said, “and we’re months away from returns of a quarter of a percentage point or more.’’

Mark Jewell writes about personal finance for the Associated Press.