Risks in Money Market Funds

Reader Kim asked, referring to my post Which Vanguard Money Market Fund? in April,

“In light of the current sub-prime meltdown, some people are questioning whether they should move out of Vanguard Prime MMF into something safer, like Vanguard Treasury MMF. Your blog helps calculate return under different scenarios but leaves off the risk aspect.  Would it be of interest to you to add in some additional calcs. to quantify the risk v. return aspect to give a better picture on each fund?  I am very interested in this issue because it is often neglected.  Thanks!”

I left off the level of risks in the different Vanguard money market funds because I thought (and still think) that difference in risks is only theoretical.

The Vanguard Treasury Money Market Fund (VMPXX) and the Vanguard Admiral Treasury Money Market Fund (VUSXX) invest only in Treasurys. They are the safest because the Treasurys are guaranteed by the full faith and credit of the U.S. government.

The Vanguard Prime Money Market Fund (VMMXX) invests in high quality, very short term debt issued by corporations. It also holds Certificates of Deposit with banks both in the U.S. and overseas. See the list of holdings from the SEC filing as of May 31, 2007.

The various tax-exempt money market funds invest in debt issued by state and local governments and their agencies. These are still safe because Vanguard only invests in issues with high credit quality.

If someone is really worried about these money market instruments defaulting, they should look at the stocks part of their portfolio because those companies would have to go bankrupt first before they default on their money market debt.

If you invest in the stock market at all, don’t worry about the money market fund. If there were massive defaults, you would likely lose a lot more money from the stock market than from money market funds. In such a scenario, money market funds would be the least of your concerns.

I don’t worry about the theoretical risk difference between the different Vanguard money market funds. However for many people the extra safety afforded by the Treasury money market fund comes for free.

The Treasury Money Market Fund yields a bit less, but because the interest income on Treasurys are exempt from state and local income tax, its after-tax yield can be higher, or at least not that much lower, than that of the Prime Money Market Fund.

When the Treasury Money Market Fund yields higher after tax, it’s a no-brainer. Even if it still yields a bit less, the difference you give up for the peace of mind may very well be worth it. It depends on how much you have in the money market fund. For example if a Texas resident (no state income tax) in 25% federal income tax bracket has $10,000 in a money market fund, the difference between the interest earned from the Treasury and the Prime money market funds is $33 a year after tax. Although I’d be fine investing in the Prime Money Market Fund, if giving up $33 a year gives someone the peace of mind, I have no problems with it. We blow much more than $33 a year on many other stuff.

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Comments

  1. Anonymous says

    I agree partly with your post, but would note that many people who put cash in money markets do so because they believe it to be 100% safe.

    You point out that in fact it is not 100% safe. Even worse, there is at least some correlation between the solvency of the money market funds and the companies issuing the debt they are investing in.

    This is precisely what you don’t want. Part of the point of diversification (stocks, bonds, cash) is to ensure that when one portion of the portfolio suffers, the others help take up the slack.

    In fact, in the case of a complete economic meltdown (as would need to occur for equity index funds to suffer massive losses), I explicitly do not want my “cash” accounts to suffer similar fates.

    I moved several large money market holdings from Vanguard Prime to the Admiral Treasury funds yesterday. I live in a high tax state, so the yield difference is very small and the extra security seems worth it.

  2. Jim Morrison says

    I find that all very interesting and I a beginning to think like people who bury their money in the back yard in a coffee can! There isn’t hardly enough interest on Money Markets today to make much difference, and apparently there is still (albeit little) risk involved. Thanks for the information, it was just what I was looking for.

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