Money Fund Investors Could Be At Risk

- Alan Lavine and Gail Liberman

But if interest rates were to spike quickly, money fund investors could suffer, warns a recent report by the Federal Deposit Insurance Corporation (FDIC). Money market mutual funds typically invest in debt obligations that mature in 90 days or less. By keeping the average maturity of the investments short, investors should not lose principal. But the funds are not FDIC-guaranteed.Investors have $2 trillion invested in money market mutual funds, according to the Investment Company Institute, Washington, D.C.

Because banks and bank affiliates sponsor approximately 33 percent of all money market mutual fund assets, the FDIC studied this issue for its May 2004 report. The FDICÕs concerns, however, apply to the entire industry.

Money fund managers may have taken on more risk to earn higher yields in the low-rate environment over the past couple of years, says Jack M. Phelps, author of the report. To get higher yields, they invested in derivatives such as collateralized mortgage obligations, credit linked notes and structured notes. They also hold commercial paper that has been downgraded by Standard and PoorÕs and MoodyÕs, and unrated paper.

"Higher risk investments tend to be more volatile and would decline in value more quickly in a scenario of sharp interest rate increases," he said.Peter Crane, vice president of iMoneyNet, Westborough, Mass., says that rising rates could pose a minor problem. There could be some isolated incidents of money funds having to buy back securities from a fund to keep the net asset value at $1, he believes. But overall, there is "no cause for concern."Bruce Bent, chairman of the Reserve Fund, the nationÕs first money fund, recommends that investors stick with money funds that do not invest in commercial paper and/or derivatives.

There has only been one official incident of money market funds liquidating. In 1994, the U.S. Government Money Market Fund, offered by Community Bankers Mutual Fund Inc., Denver, lost money due to investments in derivatives. Its investors mostly were community banks. Historically, share prices of money market mutual funds have dropped below $1 more than 50 times. But the funds dipped into their own coffers so that investors would not lose principal, according to the Securities and Exchange Commission.

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Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books). Al and Gail's new book is Rags to Retirement, (Alpha Books).