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Money Market Funds Catch Rising Interest Rates?

- Alan Lavine and Gail Liberman

Confused about what to do with your cash?

If interest rates keep rising, money market mutual funds become attractive. But as with any investment, it pays to know how to get the most bang for your buck.

Money market funds invest in short-term debt instruments that typically mature in 90 days or less. Investments generally include U.S. Treasury bills; bank CDs; commercial paper which are corporate I.O.U.s; and

or dollar-denominated CDs of foreign banks.

Money market funds, while not U.S. government guaranteed, have a special accounting system to keep their share price at $1, which means you should not lose principal. By contrast, when interest rates rise, bond prices fall. Be advised, however, that there have been times when money funds have had to kick money into a fund to keep their net asset values at $1.

Money fund managers keep the average maturity of their investments short when they think interest rates will rise. Today, they can roll money over into higher-yielding investments about every 50 days.

If short-term interest rates keep rising, you should earn higher yields in a money fund compared with U.S. Treasury bills or three-month bank CDs.

It's best, though, to invest in low-cost money market funds. The average money fund charges about one-half-of-one percent annually to manage the fund. Over the past few years, however, the funds have lowered their fees because interest rates are so low.

Here are a couple of ways to spot money funds that likely will give you the highest yields when interest rates rise.

  • Park your cash in money funds that keep their average maturities very short. This way, the fund manager can roll money over quickly to catch higher rates.

  • Invest in money funds that use "amortized cost accounting," which values all securities at cost. Funds that use this type of accounting pay higher yields in a rising rate environment. Amortized cost accounting is the most conservative method of valuing the money fund shares.

  • Invest in funds with low expenses. Go to www.imoneynet.com for more information.What about when interest rates fall? In that case, money funds that use what is known as "mark-to-market accounting," which values securities based on current prices, typically pay the highest yields.

    At this writing, the average taxable money market fund sported a yield of .51 percent with a 51 day average maturity. The average tax-free money fund yielded .49 percent with an average maturity of 34 days.

    The highest-yield taxable money fund that used amortized cost accounting was the AIM Money Market Fund Investor Class. The fund yielded .80 percent with average maturity of just 40 days. The highest-yielding tax-free fund that used amortized cost accounting and had the shortest average maturity was the Fidelity Municipal Money Market Fund. The fund yielded .70 percent with an average maturity of 28 days, according to imoneynet.com.


    Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).

    To read more columns, please visit the column archive.

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