The Federal Reserve rate cut that is expected today, whatever size it ultimately takes, has a few noble goals -- lower the cost of borrowing, stimulate the economy, assuage investor fear and entice sidelined funds back into the stock market. It also will have one unintended consequence: Investors will have few options as to where to stash their cash.
In their 30-year history, retail money market funds have never "broken the buck," so disregard any alarmists that proclaim if rates go too low the $1.3 trillion in retail money market funds will be in jeopardy of negative returns. In theory, low rates could jeopardize money market investments, but retail investors have nothing to worry about, says Jeff Tjornehoj (pronounced TURN-ahoy), a research analyst at Lipper, a
"No one's going to let a negative yield out," he says. "That would haunt them for years. It's paramount to investor trust that a fund company can at least hold onto their cash. If they can't do that, investors would head for the doors and never come back."
One place investors might head, regardless, is into bank certificates of deposit. CDs generally offer higher rates than money funds, because they require a specific time commitment. (Investors who pull cash out before the allotted time risk stiff penalties.) But with yields on money funds razor-thin and unlikely to turn around, and CDs seeming more secure, investors may not see the lock-up period as a big sacrifice.
Money market funds aren't federally insured the way traditional savings accounts or bank CDs are, but the fund companies that offer them use strong language assuring investors that the value of one share will always be $1. While the net asset value, or NAV, of virtually all money market funds is kept to $1, the interest yield changes daily as managers buy and sell short-term securities that make up these funds. If short-term rates are moving higher, money market fund yields also go higher. Typically, the fund's fees are taken out of the yield.
When rates drop, as they have for two years, yields also decrease. When the yield on money funds is less than the fees charged by the fund, investors theoretically risk losing principal to those fees -- hence "breaking the buck." This really is theoretical, though, because in the history of retail money market funds, no fund company has allowed this to happen.
The federal funds rate (also called the overnight rate because it's what banks charge one another for overnight loans) has stood at 1.25% since the last cut in November 2002. The rate, now at its lowest level since the 1950s, likely will be cut 25 to 50 basis points on Wednesday.
The average gross yield (before expenses) on a retail money fund is 1.4%. Subtract the average expense ratio of 92 basis points (or 0.92%) and that's an average yield of 51 basis points. A 50-point rate cut would decimate most yields, and theoretically send some of the pricier funds into negative territory.
But rather than let that happen, Tjornehoj says, the fund companies will eat their fees, preserving some yield for investors. (Some money funds were expected to do so after November's rate cut; see
Breaking the Buck is Hard to Do.)
A far more troubling aspect of the rate cut, Tjornehoj says, is the inroads bank products are making in cash management. Money market funds are particularly popular among investors still musing about when to get back into the market. But with yields so low, investors are likely to be tempted by higher-rate bank CDs. A six-month CD averages a 1.29% yield; a one-year pays 1.57%. If investors are lured by higher rates and the perception of increased security, cash intended for the markets may end up tied up in banks for the near future.
"It could be difficult to get investor money into a rallying market if investors go into CDs," Tjornehoj says. "Some investors might be forced to sit out while the market continues to rally."
And that consequence of the rate cut -- albeit on the margins -- is surely not what the Fed intends. Nor should it be what investors allow.