Everyone knows owning stocks involves risk. But owning cash? That's risk-free -- right?
For many investors who hold money market mutual funds, the answer is no. As The Wall Street Journal discussed yesterday, lurking within some of these funds are exactly the same types of mortgage-backed securities that have the stock and bond markets spooked.
The risky business of cash
Money market mutual funds come in several different categories. Tax-exempt money funds hold state and local government obligations, which produce tax-free income. Among taxable money funds, some hold only Treasury bills, notes that are backed by the full faith and credit of the federal government.
However, other types of money market funds offer better yields than those that simply own Treasuries. Government money funds hold obligations of government-sponsored agencies, such as those issued by Fannie Mae (NYSE: FNM ) and Freddie Mac. Other funds own short-term corporate debt issued by a wide range of companies.
The concern expressed by The Wall Street Journal focuses mostly on these latter funds, especially those that hold commercial paper. A large portion of the commercial paper that money funds own is backed by assets of the issuer. This should make these securities safer than if they were unsecured. But the article suggests that by using loosely regulated vehicles called conduits to package assets into asset-backed commercial paper, financial institutions are moving risky subprime debt off their books.
What funds own
Money funds generally try to find the safest investments they can while generating a competitive yield. If you pick a fund and look at its holdings, you'll probably see a number of highly reputable names. For instance, T. Rowe Price's Prime Reserve Fund holds commercial paper from large corporations like IBM (NYSE: IBM ) , AT&T (NYSE: T ) , and Wal-Mart (NYSE: WMT ) . Financial institutions are also well-represented, including General Electric's (NYSE: GE ) GE Capital division, Lehman Brothers (NYSE: LEH ) , and Merrill Lynch (NYSE: MER ) . Yet you'll also see names like Jupiter Securitization -- a conduit program.
Yet conduit financing doesn't necessarily translate to high risk. According to a Moody's report on asset-backed commercial paper, a properly structured conduit can reduce the structural risks involved, along with liquidity and credit risks.
Breaking the buck
Nevertheless, the Journal article's assertion that some conduits have asked for extensions to make payments on their commercial paper has made some investors nervous. The $1 share price that most money funds constantly hold is so fixed in investors' minds that the idea that a fund could "break the buck" and lose value horrifies them.
In the past, money fund managers have absorbed similar losses themselves rather trying to pass them on to their shareholders. But they aren't under any legal obligation to do so, and if you read your prospectus, you'll see that while money funds seek to keep their share prices constant, there's still a risk of loss.
What to do
In all likelihood, the vast majority of money market mutual funds will continue to operate as they always have. Just as in previous financial difficulties, the subprime crisis will eventually get resolved. Your risk of losing money in your money fund is pretty low.
If you're extremely risk-averse, however, there are actions you can take to reduce even that small level of risk. If your fund manager also offers a Treasury money fund, exchanging into that fund would leave you with safer investments -- albeit with a likely drop in income. Similarly, many bank savings accounts and CDs offer rates that are competitive with money market funds, and they have the benefit of being FDIC-insured up to $100,000.
When markets are falling and your portfolio is hurting, the last thing you need to worry about is whether your cash is safe. Even though it's probably unnecessary, sacrificing a bit of interest is a small price to pay for peace of mind in troubled times.
Get the scoop on making the most of your cash in our Savings Center.
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Fool contributor Dan Caplinger has most of his short-term cash in Treasuries. He doesn't own shares of the companies mentioned in this article. Wal-Mart and Fannie Mae are Motley Fool Inside Value recommendations. The Fool's disclosure policy is safer than a safe.