Where to Find the Best Yields Now

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Investors have fled to the safest investments they can find. Yet while supposedly safe blue chips like AT&T (NYSE: T) and ExxonMobil (NYSE: XOM) have felt the pain just like the rest of the stock market, one surprising area of the financial markets has lost investor confidence as well -- driving yields up to incredibly attractive levels.

The once-quiet world of money market mutual funds has turned upside down. Once relied upon as a no-risk safe haven, money market funds have hit the headlines, as the credit crisis has revealed that some funds have more risk than others. Although returns for various money market funds used to track each other pretty closely, you can now see huge differences in yields, depending on which type of fund you own.

Muni madness
As with stocks and other investments, rates in the money market world tend to rise as risk increases. So ultra-safe money market funds that hold only Treasury debt have extremely low yields -- around 1.5% to 1.7%. Higher-yielding money market funds that hold corporate debt pay a bit more -- around 2.3%.

Those small differences in rates make plenty of sense -- in a tight credit environment, corporate issuers have to pay a premium to get investors to own their debt. But where traditional rate relationships have broken down is in the tax-exempt municipal money market. Although you might consider state and local governments to be no riskier than corporate issuers, the rates governments are having to pay for short-term borrowing have gone sky-high -- above 5% as of yesterday.

When you consider that interest on tax-exempt municipals is free from federal income tax, making that 5% equivalent to nearly 7.7% in a taxable investment for someone in the 35% tax bracket, you can see that things don't make sense right now. Are munis a great opportunity, or the latest value trap?

Danger ahead
Clearly, some investors are concerned about the financial condition of state and local governments. California governor Arnold Schwarzenegger's recent request for $7 billion in emergency aid from the federal government is just one extreme example of the financial difficulties many states and municipalities are suffering. As property values drop, tax bases are falling, thereby resulting in lower revenue. A slowing economy reduces spending, causing sales tax revenue to decline. And with unemployment rising, state and local income tax revenue may start to disappear as well -- especially in areas like New York City, which will be hit hard by Wall Street's woes.

Yet at least in the money-market realm, municipal investors' concerns are overblown. For one thing, many municipal obligations are insured by firms like MBIA (NYSE: MBI) and Ambac Financial (NYSE: ABK), which have recovered somewhat from concerns that they were undercapitalized. But more importantly, higher short-term muni rates come not from default worries, but rather from the same liquidity problems now plaguing banks and other financial institutions. Many of the investments that municipal money market funds own are variable rate demand notes, which have rates that reset every week or month. The credit crunch has caused bids in those markets to dry up, causing rates to go sky-high.

Although there are similarities, the problem isn't the same as the one earlier this year in the auction-rate securities market, which cost millions for companies such as Palm (Nasdaq: PALM), Metro PCS (NYSE: PCS), and Bed Bath & Beyond (Nasdaq: BBBY). In contrast to companies that need immediate liquidity for their short-term funds, muni money market funds are more than happy to accept high rates in exchange for a temporary loss of liquidity -- as long as their fund shareholders don't all try to take redemptions at the same time.

Several experts believe that once the financial system returns to more normal functioning, muni money market yields will return to lower levels -- likely within the next month or so. Therefore, it's probably not worth going to a lot of trouble to move money into these funds to take advantage of a very short-term anomaly.

If you're lucky enough to be an investor in these funds, however, enjoy the great yields while they last. It's an opportunity you may never see again.

For more on malfunctioning markets, read about:

• Why Cramer thinks it's time to panic.
• How you can panic-proof your portfolio in 5 minutes.
• An outrageously cheap stock you can't afford to miss.