Continue to site >
Trending ETFs

Prime Money Market Funds: Extra Yield Opportunity or a Risky Bet?

It’s an exciting time to be a fixed income investor. Yields on a variety of bonds and other fixed income securities are now at highs not seen in roughly a decade. And that includes plain old cash. Yields on savings accounts, CDs, and money market funds are now over 4% in many cases. But despite the fact that ‘cash is king,’ not all cash is the same. Some is riskier than others.

In this case, we’re talking about prime money market funds.

Prime funds have had some major mishaps over the last decade or so and aren’t exactly risk free. That could be a big issue for investors given their perceived safety and security. With some fixes in the works from the SEC, the question now is whether or not a prime fund is worth holding for the slight bump in yield.

Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.

Not All Money Market Funds Are the Same

No matter what an investor’s allocation or timeline, there’s always a need for liquidity and savings. To that end, money market funds—which are not to be confused with money market bank accounts—have long served as that source of liquidity/savings for portfolios. These funds invest in very short-term securities such as Treasury bills, commercial paper, bankers’ acceptances, repurchase agreements, and certificates of deposit (CDs). Sometimes the maturities on these assets are as short as overnight. As such, money market funds are designed to provide stability of a stable $1 per share price, liquidity, and steady interest payments for investors.

Explore all money market funds here and check out all the available options.

But not all money market funds are the same. Regulations from the U.S. Securities and Exchange Commission (SEC) place money market funds into one of three categories.

The first is easy to explain and that’s government funds. Here, these funds are required to hold U.S. Treasury securities and CDs. Some will also hold repurchase agreements that are collateralized by U.S. Treasury securities as well as debt from government-sponsored enterprises like Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. The idea is that you’re holding mostly debt from Uncle Sam and his friends.

The second category is municipal, which is debt issued by states, towns, and other local government entities.

The third category is where it gets a little sticky. These are called prime money market funds. These funds can invest in all of the above as well as commercial paper, corporate notes, repos, and other short-term private instruments from domestic and foreign issuers. By taking on some additional non-government risk, investors in prime funds can typically score an extra 25-30 basis points more in yield than a government-only fund.

When Risk-Free Doesn’t Add Up

The problem is that prime funds have often been billed as safe and secure. But they aren’t risk-free and have not lived up to their liquidity mandates in times of duress. Generally, there is a very healthy market for commercial paper, repos, and other short-term corporate asset classes that prime funds hold. The issue becomes the stampede of investors seeking liquidity at the same time.

This has happened twice now within the last decade. Once was during the Great Recession; the other was during 2020 and the COVID-19 pandemic. Both times, the Fed was forced to intervene in the overnight repo and commercial paper market, providing liquidity. For investors in prime funds, the situation was anything but ideal.

During the Great Recession, we had a major event when the Reserve Primary Fund—which was one of the largest prime funds—broke the buck’ and saw its NAV fall below $1 per share. This sent a shockwave through investors, exacerbating the situation, drying up liquidity further, and causing the SEC to limit withdrawals from prime funds altogether. Rules enacted since then required the NAV on prime funds to float and be extended out to $1.000. This means that prime funds can move below a dollar if needed. Moreover, new rules allow for gatekeeping of withdrawals to prevent future surges of investor demand and forced liquation of assets.

We saw this occur during the COVID-19 pandemic, when once again liquidity dried up as investors ran for the exits in the commercial paper and repo market. Prime money market funds were tested.

Risks Lurking

All in all, money market funds are supposed to be a source of liquidity and safety for a portfolio. But if that liquidity dries up due to the underlying assets or via gatekeeping and the stability is gone via a floating net asset value, they aren’t living up to their promise. And while many of these issues have come on the institutional side of prime funds, proposals have been floated to make them standard on retail accounts as well. Moreover, many fund companies have started to do away with prime funds, merging them away or liquidating them.

To that end, investors need to decide if the extra 0.25% in yield is worth the additional risk of a prime fund, particularly when the economy is starting to get dicey today. The answer may be no, at least not for all of a portfolio’s cash holdings. Pairing a prime fund with a government fund could provide the optimal yield plus liquidity/safety needed.

Another option? Cash-life ETFs.

Funds like the iShares Ultra Short-Term Bond ETF (ICSH) or SPDR Ultra Short-Term Bond ETF (ULST) are essentially prime funds. But because of the creation-redemption mechanism of ETFs, liquidity happens in the secondary market. During the pandemic, the largest cash-life ETFs functioned just fine and provided plenty of liquidity for their shareholders.

The Bottom Line

Not all cash is the same. Prime money market funds may offer a bit of yield, but investors shouldn’t ignore the risks. Ultimately, there are better solutions that provide safety and liquidity, without prime fund’s potential headaches.

Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.

author avatar
Feb 21, 2023