The yields on many money market funds are now at 5% or higher (pre-tax), making them a more attractive place to park cash than they have been for several years. Since there are four major types of money market funds, investors often wonder: Which type of money market is the safest given that they are not FDIC-insured; and is it worth it to chase yield given that a money market fund can lose value theoretically?
There are no absolute answers. When I characterize the relative risk of money market funds, I typically use the analogy of paint finishes — “eggshell” vs. “satin.” Money market funds are fairly similar when it comes to risk, partly because they are heavily regulated. Their relative risk depends on the type of financial or economic crisis being faced. If during such a crisis a money fund were to “break the buck,” or lose value (net asset value falls below $1 per share), chances are that other asset classes would probably be facing much greater challenges warranting investor attention.
With that said, money market funds are supposed to keep a constant value, unlike risk assets. Yet there is some quantum of risk in money market funds, and that is why you get a higher incremental yield as you move from a Treasury fund to a Prime fund. Between these two on the risk spectrum are Government and Municipal money market funds:
TREASURY funds — invest only in U.S. Treasuries and some instruments that are backed by Treasuries.
GOVERNMENT funds — add the obligations of government agencies, such as those issued by FNMA and FHLMC, which have an implied federal guarantee.
MUNICIPAL funds — short-term municipal securities and floating rate notes called VRDNs (Variable Rate Demand Notes), which essentially were created to build out muni money market funds.
PRIME funds — U.S. Treasuries and government securities (as with Government funds) PLUS commercial paper (ultra-short-term corporate debt) and a few other instruments such as bank time deposits and CDs.
Depending on the nature of the financial shock, it is not at all clear that performance would be meaningfully different between these four types of funds. In practice, the risks of money markets have been tested very infrequently, and the results in those circumstances would be better described as a near-term loss of liquidity rather than real financial loss for the investor.
Regulation and Reputation
Stricter money market regulations (Rule 2a-7) after the 2008 Financial Crisis and then again during COVID in 2020 have dis-incentivized mass withdrawals and reduced the type and amount of risky securities money market funds can hold. This has greatly reduced, although certainly not eliminated, the probability of problems in the space.
As part of these changes, the SEC bifurcated the market into retail and institutional money market funds (with floating NAV) to prevent traditional, retail-oriented funds from breaking the buck because of large institutional withdrawals. The U.S. government has also demonstrated it stands ready to backstop money markets if they needed, making the likelihood of money market losses low. Additionally, there is tremendous business and reputational risk to money fund providers in not being able to give their investors their money back (breaking the buck), and something to be avoided at all costs.
The most important factor to consider in evaluating money markets: the after-tax yield and whether it is worth picking up a few basis points in extra yield (or more in some environments) while taking on slightly higher liquidity risk (temporarily losing access to your cash should there be a financial system shock). As with anything, diversification helps lower risk: Do not put all your cash holdings in one place. Also, keep in mind that relative yields fluctuate and the decision you make today might look less optimal over time, so periodic review is important.
