SF Gate: INVESTING/Breaking the buck

From: Rakesh Bhandari (rakeshb@STANFORD.EDU)
Date: Thu Jun 26 2003 - 18:40:10 EDT

Interesting analysis of the problems that money market funds could
have as the Fed eases. Which may put limits on much the Fed can ease.
Greg Ip made the same points in the Wall Street Journal recently, but
Kathleen Pender of the SF Chronicle lays them out better.
yours, rb

Thursday, June 26, 2003 (SF Chronicle)
INVESTING/Breaking the buck
Kathleen Pender

    By cutting the federal funds rate by only one-quarter of a percentage
point instead of one-half, the Federal Reserve helped ease fears that some
money market mutual funds might "break the buck" and yield less than zero.
    That's good news for money-fund purveyors, but small consolation for long-
suffering savers who will see their paper-thin rates become even more
    The average yield on money funds will fall from 0.64 percent today to 0.44
percent in the next few weeks, predicts IMoneyNet.
    Rates on bank certificates of deposit had already fallen since the Fed's
open market committee hinted at its meeting on May 6 that another rate cut
was possible. But CD rates could fall a bit more now that the federal
funds rate has been sliced to 1 percent from 1.25 percent, says Greg
McBride of Bankrate. com.
    Even as rates have fallen, savers in recent months have favored CDs and
other bank products over money market funds, perhaps because bank accounts
are insured up to $100,000 each.
    Although money funds are not guaranteed, until recently many savers
regarded them that way.
    Money market funds pool investors' money to buy short-term investments
such as Treasury bills (issued by the federal government) and commercial
paper (unsecured promissory notes issued by corporations).
    Money funds are priced at $1 per share. If a fund were to fall below $1
per share -- a situation known as breaking the buck -- shareholders could
lose money.
    This could happen if some of the fund's investments blew up. In the past,
a few funds have suffered losses that threatened to drive their share
prices below $1. But in each case (except possibly one), the fund company
reimbursed the fund so it didn't break the buck.
    A money fund also could break the buck if its investment income fell below
its operating expenses. Until recently, this would have been unthinkable.
    Money fund investments typically yield close to the federal funds rate.
    As a result, money market funds roughly yield the federal funds rate minus
the annual expense ratio they charge shareholders to cover operating costs
and to provide (in good times) a profit to the fund company.
    The average expense ratio for money funds is about 0.5 percent of assets.
When the federal funds rate was 1.25 percent, this left about 0.75 percent
a year for shareholders (although the average yield was slightly less).
    But some funds charge 1 percent a year or more in expenses, which leaves
next to nothing for shareholders.
    These are mainly B- and C-class shares of funds sold through brokers or
financial advisers who collect an annual commission from the fund. To pay
these commissions, the fund company charges exorbitant expense ratios.
(It's the gift from shareholders to brokers that keeps on giving.)
    As of June 17, there were 209 money market funds yielding 0.25 percent or
less, according to IMoneyNet.
    With the federal funds rate dropping by 0.25 percentage point, all of
these funds are in danger of breaking the buck, unless the fund companies
reduce their expenses. Some are doing so already.
    Blessedly, these funds account for only 2.9 percent of total money market
fund assets. But if one or more of them broke the buck, it could send
shock waves through the industry.
    There were an additional 356 funds yielding 0.25 to 0.5 percent,
representing 11.7 percent of money fund assets, as of June 17.
    Had the Fed cut its key interest rate by 0.5 percentage point, these funds
also would have been in break-the-buck territory.
    That could be one reason the Fed opted for the smaller interest rate cut.
    Money funds, with about $2.1 trillion in assets, make up 35 percent of
total mutual fund assets.
    If investors were to lose faith in money market funds, that could drive up
borrowing costs for corporations and the U.S. Treasury -- at the same time
the Fed is trying to drive them down.
    "The Fed knows if nobody wants to buy commercial paper, the only way to
get people to buy it is to push rates up," says Crane.
    To stay above a buck, Crane says, money funds will cut costs, and try to
renegotiate commissions with brokers.
    For example, Franklin Templeton Money Fund's class B shares are yielding
0. 04 percent.
    "On the FT Money Fund (B shares) we are currently waiving expenses to
avoid breaking the buck," says Franklin spokeswoman Lisa Gallegos. "We
have sent a note to shareholders letting them know that Franklin Advisers
Inc., has agreed to reduce all or a portion of its advisory fees, and if
necessary, to assume certain other expenses to ensure that it maintain a 3
basis point yield (0.03 percent) for its shareholders."
    (This is not to be confused with the larger Franklin Money Fund, which is
yielding 0.56 percent.)
    Some of the larger money funds yielding 0.25 percent or less in mid-June
were Evergreen Money Market Fund class S, Alliance Government Reserves, E-
Trade Money Market Fund, Galaxy Prime Reserves and Alliance Capital
Reserves, according to IMoneyNet.
    The nation's three largest money funds -- Fidelity Cash Reserves, Schwab
Money Market and Vanguard Prime -- were yielding 0.92 percent, 0.48
percent and 0.87 percent, respectively, as of June 25, according to
    Among the 20 largest funds, the lowest-yielding was Alliance Capital
Reserves, at 0.23 percent.
    Although rock-bottom yields are hard to stomach, the main reason to own a
money fund is to preserve principal.
    Investors should check their money fund yield. (Be sure to pick the right
fund and share class.) If it's so low the fund could break the buck,
consider switching to another fund or a bank money market deposit account.
    A few banks are paying more than 2 percent on these accounts, but they
allow no more than six withdrawals per month, so they can't be used like a
checking account or money fund. (You can find them at www.bankrate.com
under money markets.)
    Ideally, investors should keep only as much money as they need for current
expenses and emergencies in a money market fund or deposit account.
    The rest of their money should be in a wide variety of stocks and higher-
yielding income investments, such as bond funds, stable value fund, CDs of
various maturities, dividend-paying stocks and real estate investment

    Average interest rates and yields now and on May 6, the last time the
Federal Open Market Committee met.
    Investment                         Latest   May 6
    Money market fund                  0.64%    0.70
    Tax-free money market fund          0.55     0.77
    Bank money market deposit account   0.61     0.67
    Six-month CD                        0.97     1.10
    One-year CD                         1.09     1.26
    Two-year CD                         1.41     1.73
    Three-month Treasury bill           0.91     1.10
    Two-year Treasury note              1.29     1.43
    10-year Treasury note               3.40     3.79
    Sources: IMoneyNet, Bankrate.com, Bloomberg

Copyright 2003 SF Chronicle

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