Money Market Funds ….Risky?

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The short-term solution in the current environment

As our economy is in a deep recession, investment options are very challenging. A useful place to invest in the short term is the money market. Money Market Accounts can be opened at all financial institutions such as your local bank. You can also invest in a money market fund which is a combination of money market accounts with various banks.

It is very difficult at the moment to get a return of around 5% with an extremely low risk of losing your capital. I say low risk because there is a very low possibility that money market funds may be exposed to debt instruments which carry the risk of default. This could in turn lead to a capital loss.

What is it all about?   A money market account trades in bank instruments called “paper”, such as Treasury bills, Banker’s acceptances, certificates of deposit, and bills of exchange which all trade in a period of less than a year.
The money market trades at the so-called ‘interbank’ level where banks lend and borrow to each other. These wholesale rates are higher than the retail rates offered by banks on their savings accounts.

Don’t be lulled into higher yields   If the fund is offering exceptionally high yields it may be riskier than you think. The fund may be invested in low-grade debt (bonds) which often pay a higher return for the risk. The economy is on its knees and corporate debt poses a risk as companies struggle to get back up on their feet.                                

                                                                                                                           

Interpret the rate correctly   The nominal rate is the actual rate of return – normally annual. The effective rate is the rate achieved by reinvesting the interest received and compounding it back into the investment.

Example:
A nominal rate of 7% per annum yields an effective rate of 8.25% over a 5-year period.
If you draw out the interest then you do not get the effective rate. You actually get the nominal rate.
The real rate is the adjusted rate received after subtracting the inflation rate.

These are extraordinary times    In an environment where cash is king, money market accounts are very useful parking bays but be very aware of the possibility of capital loss in the event of the debt exposure defaulting.

580 thoughts on “Money Market Funds ….Risky?”

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