Understanding Money Market Fund

4.1 About Money Market Fund

Earlier people had hundreds of alternatives for safely investing their spare cash – they could go around town and shop among banks, banks, and still more banks. Although it may seem that safe-money investors had many alternatives, they really didn’t. As a result, yields weren’t all that great compared with what a large institutional investor with millions of rupees to invest could obtain by purchasing ultrasafe short-term securities.
Then in the early 1997, money market mutual funds were born. The concept was fairly simple. The money market mutual fund invested in the same safe, higher-yielding financial instruments that only those with big bucks could buy. The money market fund then sells shares to investors who don’t have vast sums to invest. By pooling the money from thousands of investors, the fund offers investors a decent yield (after charging a reasonable fee to cover the operational expenses and make a profit).
Thus, Money market mutual funds are a large and unique part of the mutual fund industry’s offering. Money market funds are the only type of mutual fund whose share price doesn’t fluctuate in value a lot. The share prices of stock and bond mutual funds fluctuate from day to day depending on how the stock and bond markets are doing.

4.2 Comparing Money Funds with Bank Accounts

Savings bank accounts are considered the only investment option which generates risk-free returns. Moreover, you are assured of the interest being credited to your account. A major disadvantage is that most banks generally do not revise the interest rates on savings bank accounts frequently.
Although money market funds are not entirely risk-free, however, they are low risk-low returns instruments. As they invest predominantly in debt instruments, they are subject to interest rate risk and credit risk. A change in the prevailing interest rates may cause a difference in the price of the debt instruments. This, in turn, may cause the NAV of the liquid fund to fluctuate. Since liquid funds invest mainly in short-term debt securities, you may not find sharp fluctuations in the NAV of liquid funds.
When discussing credit risk, it refers to the likelihood of default in the payment of interest and principal by the issuer of the debt instrument. Liquid funds ensure that your money is invested only in superior creditworthy instruments.

4.3 Using Money Market Funds

The best money market funds are the ideal substitute for a bank savings account – offering equivalent safety to a bank, but a much better yield. Money market funds are well suited for some of the following purposes:

o Your emergency cash reserve: Money market funds are a good place to keep your emergency cash reserve. Because you don’t know what the future holds, you’re wise to prepare for the unexpected – events such as job loss, unanticipated medical bills, or a leaky roof. Three to six months’ worth of living expenses is a good emergency reserve target for most people (for example, if you spend Rs.30,000 in an average month, keep Rs90,000 to Rs.1,80,000 reserved). Additionally- consider keeping up to one year’s expenses handy if your income fluctuates wildly. If your profession involves a high risk of job loss, and if finding another job could take a long time, you also need a significant cash safety net.

o Short-term savings goals: If you’re saving money for a big-ticket item that you hope to purchase within the next couple of years – whether it’s a fishing boat or a down payment on a home – a money market fund is a terrific place to accumulate and grow the money. With such a short time horizon, you can’t afford to expose your money to the gyrations of stocks or longer-term bonds. A money market fund offers not only a safe haven for your principal but also a yield that should keep you a step ahead of the inflation rate.

o A parking spot for money awaiting investment: Suppose that you have a chunk of money that you want to invest for longer-term purposes but you don’t want to invest it all at once for fear that you may buy into stocks and bonds just before a big drop. A money market fund can be a friendly home to the money awaiting investment as you purchase into your chosen investment gradually over time.

4.4 What Money Funds invest in?

Money market funds can invest only in the most credit-worthy securities, and their investments must have an average maturity (when the short-term bonds pay off) of less than 90 days. The short-term nature of these securities effectively eliminates the risk of money funds being sensitive to changes in (short-term) interest rates.
The securities that money market funds use are extremely safe. General purpose money market funds invest in government-backed securities, bank certificates of deposits (CDs), and short-term corporate debt issued by the largest and most credit-worthy companies and the Indian government bonds.

A) Commercial paper- Corporations, particularly large ones, often need to borrow money to help make their businesses grow and prosper. In the past, most companies needing a short-term loan had to borrow money from a bank. In recent decades, issuing short-term debt or IOUs – commercial paper – directly to interested investors has become easier. Money market funds buy high-quality commercial paper that matures typically within 60 to 90 days and is issued by large companies (such as Tata, Reliance, TCS), banks, and Government.

If you had hundreds of thousands of rupees to invest, you could purchase commercial paper yourself instead of buying it indirectly through a money market fund. If you don’t have a lot of money to invest, directly investing is not a great idea. You incur fees when you purchase commercial paper yourself, and you most likely lack the expertise to know how to evaluate credit risks and what a fair price to pay is. The best money funds charge a small fee to do all this analysis for you, plus they offer perks, such as check-writing privileges.

B) Certificates of deposit: You can go to your local bank and invest some money in a certificate of deposit (CD). A CD is nothing more than a specific-term loan that you make to your banker — ranging anywhere from a month to some number of years. Money market funds can buy CDs as well. The only difference is that they invest a lot more money – usually millions – in bank CDs. Thus, they can command a higher interest rate than you can get on your own. Money funds buy CDs that mature within a few months. And as with other money fund investments, the money fund does research to determine the credit quality of banks and other institutions that it invests in.

C) Government Debt: McDonald’s has signs in many locations saying that billions and billions have been served. Well, the government also serves up trillions and trillions – of rupees in debt, that is – in the form of Treasury securities. Most money market funds invest a small portion of their money in Treasuries soon to mature. Money funds also invest in short-term debt issued by government-affiliated agencies, such as the NABARD, which provides funds for agriculture development of India.

Government agency debt, which money funds also invest in, unlike Treasuries, isn’t backed by the “full faith and credit of the Indian government.” However, no federal agency has ever defaulted on its debt and such a situation is unlikely to happen.