Question: I’d like to invest a portion of my cash holdings in something safe that will earn at least a little interest. Between a money market account and a short-term bond fund, which is the better choice?
Answer: If you’re looking for a place to keep your money safe while still keeping it relatively liquid, money markets and short-term bond funds are good places to start. A certificate of deposit (CD) could also fill the bill; but assuming that you want to be able to access the funds without paying a penalty, a money market or short-term bond fund is a better choice.
Before we address the relative safety of each investment type, let’s take a look at their yields to determine where the best payouts are.
The Yield Question
Short-term bond funds currently yield around 1% on average, although some pay more than double that amount by taking on additional credit risk (more on that later). Money markets come in two flavors: money market accounts offered by banks and money market funds offered by mutual fund companies. Money market mutual funds pay just a measly 0.01% on average these days, and that’s often with fund companies subsidizing them (contributing extra money) to help keep their yields positive. Bank money market account yields are only slightly better at about 0.11% on average, according to Bankrate.com.
However, some banks–particularly online banks–offer money markets with yields that rival those of the average short-term bond fund. Some of these online money market accounts require minimum balances that may be prohibitive for some investors, and if you do decide to use one, make sure the rate you’re getting isn’t an introductory rate that will go away in a few months.
For investors who prefer to keep their liquid reserves under one roof or who are uncomfortable putting their money in an online bank, using a brick-and-mortar bank or fund company’s money market may be worth the lower yield for the added convenience. But before making a decision about which investment vehicle to use for your cash, make sure you understand the risks involved.
Not All Money Markets Work the Same Way
Bank and fund company money markets have some important differences. Among them is the fact that bank money market accounts typically are protected by the Federal Deposit Insurance Corporation, or FDIC, an independent agency of the federal government. That means that if the bank offering the money market goes out of business, investors can recoup up to $250,000 in lost funds.
Money market funds are not guaranteed by the FDIC, although they may be protected by SIPC, the Securities Investor Protection Corporation, if the fund company or brokerage is a member. (SIPC is a nonprofit corporation created by the federal government and funded by member financial institutions.) SIPC treats money market funds as securities, meaning they are subject to a $500,000 guarantee if the fund company or brokerage offering them fails.
Most importantly, while bank money market accounts are guaranteed not to lose value, the same cannot be said of money market funds offered by fund companies.
Historically, fund companies have used a net asset value of $1 per share for their money market funds, and only rarely has the performance of the fund’s underlying holdings caused this to waver. However, during the financial crisis in 2008, one money market fund, Reserve Primary Fund, “broke the buck,” meaning that the net asset value of its shares fell below the $1-per-share standard after Lehman Brothers debt securities held in its portfolio lost value. The federal government stepped in to temporarily guarantee that investors in all money market funds would not lose money; but in the aftermath of that event, the SEC began taking a long, hard look at money market mutual funds and, in particular, the question of whether fund companies should be allowed to “artificially” maintain the $1-per-share standard by adding assets to a money market fund when its underlying holdings lose value. In July of this year, the SEC finally issued new rules that require money market funds for institutional investors to have a floating net asset value–in other words, to accurately reflect the value of the underlying holdings–though, money market funds for retail investors aren’t affected.
Short-Term Bond Funds: Maybe Not So Low-Risk After All
Short-term and ultrashort bond funds have something in common with money market mutual funds in that all three invest in short-term fixed-income securities. However, while a money market mutual fund might own very short-term securities with maturities of 60 days or so, short-term and ultrashort bond funds typically own bonds with maturities that are somewhat longer.
Morningstar defines ultrashort bond funds as those investing in bonds with durations of less than one year and short-term bond funds as those investing in bonds with durations of between 1 and 3.5 years. (Duration is a measure of interest-rate sensitivity based partly on the bond’s maturity.)
Because they invest in bonds with longer maturities than those used by money market funds, short-term bond funds, in particular, are more subject to interest-rate risk. After all, if rates rise, the value of a 60-day bond will be less affected than the value of a 3-year bond. That’s because when interest rates rise, the value of existing bonds drops to make the lower yields they pay more attractive to investors. For bonds with longer maturities, this effect is more pronounced than for bonds with shorter maturities.
But that’s not the only potential risk factor present with short-term bond funds. Morningstar senior fund analyst Eric Jacobson says credit risk is another. “A handful of short-term bond funds have notably large allocations to mid- and lower-quality bonds,” he says. “Most investors tend to use this category as a place to find funds for the most conservative allocations of their portfolios. As such, it’s extremely important to recognize that while none of the funds in the [short-term bond] category breach our rules to the point of warranting a change to another category, several are close, and an even larger number of funds in the group have taken on meaningful credit risk.”
It’s worth noting that in 2008, when the financial crisis raged and investors fled credit-sensitive bonds, the average short-term bond fund lost 4.2%. And while the ultrashort bond category didn’t exist back then, Christine Benz, Morningstar’s director of personal finance, writes here that some ultrashort bond funds dip into lower-quality issues as well. Money market funds, on the other hand, are restricted from owning below-investment-grade securities, meaning that there is much less risk of default on the securities they own.
For a combination of safety and yield, an FDIC-insured online bank money market account may be your best bet, at least for now. That could change if and when interest rates rise if such an increase would allow short-term bond funds to begin paying yields that are significantly higher than money market yields. But given today’s choice between a guaranteed rate of close to 1% and a nonguaranteed rate that’s not much higher, you’re probably better off with the former.