For years, wary investors retreated to the safety of money market mutual funds when stocks seemed too risky. Now, though, these safe-haven investments have become an endangered species -- but that's OK, because you don't need them anymore.
The rise and fall of money market funds
When money market mutual funds first became available 40 years ago, they provided a way for investors to earn a competitive interest rate on their cash. Bank savings accounts were regulated and paid relatively low rates on deposits, and other investments required larger balances than many investors had available. Money market funds opened up more lucrative investments to small investors, especially during the late 1970s and early 1980s, when high interest rates made it important to maximize the return on your cash.
Today, the tables have turned on money market funds. The Federal Reserve has set short-term interest rates at rock-bottom levels, and corresponding rates are so low on short-term Treasuries, agency securities, and even commercial paper that many money market funds are having trouble earning enough interest just to pay for their expenses. Legg Mason
Why waste your money?
The biggest surprise about this isn't that companies are starting to give up on their money market funds. Rather, it's why this didn't start happening sooner -- and why customers are still keeping their money in the funds at all.
According to Crane Data, the average money market fund is paying 0.10% interest right now. Even the top-yielding fund available to individual investors pays just 0.27%. Meanwhile, many funds pay as little as 0.01%.
Moreover, even some money market funds aren't entirely safe. If you pick a fund that invests solely in Treasury bills, then you don't have to worry much about a default. But with so-called "prime" money market funds, which invest in commercial paper, an issuer that runs into credit problems can sink a fund.
That's what happened to the Reserve Primary Fund, the first money market fund, in 2008. It held a sizable position in Lehman Brothers commercial paper, and when Lehman went bankrupt, the money market fund suffered such big losses that it had to "break the buck" and froze redemptions until it could liquidate.
Higher rates, better protection
In contrast, you can find many banks that are willing to pay you a whole lot more than that. The banking divisions of Capital One
In addition to getting more interest for your money, the other big advantage that savings accounts offer is that they're backed by the Federal Deposit Insurance Corp. up to $250,000. In other words, you don't have to worry about a fund breaking the buck; even if your bank happens to go under, you'll still get all of your money back, as long as you stay below the $250,000 limit.
Make your money work harder
Of course, earning 1% may not sound like it's worth the hassle of switching out of a money market fund. But with no sign that the Federal Reserve plans to raise interest rates anytime soon, you may see more financial companies taking matters into their own hands. If their moves force you to move to a better-yielding alternative with your cash, then it'll be a win-win for everyone involved.
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Fool contributor Dan Caplinger goes wherever he sees the most interest. He doesn't own shares of the companies mentioned in this article. American Express, Discover Financial Services, and Federated Investors are Motley Fool Inside Value selections. Charles Schwab is a Motley Fool Stock Advisor pick. The Fool owns shares of Legg Mason. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy always generates a high rate of interest.