Master the Money Market
The money market is a collective name that describes all the different ways in which governments, banks, corporations and securities dealers borrow and lend money for short periods.
Money-market loans may be due in a few days, a few weeks or a few months, but never more than a year. Thus, short-term certificates of deposit are considered to be in the money market. Treasury bills, which mature in three, six, nine or 12 months, are money-market instruments. Other short-term investments that could be in a typical money-market portfolio include:
- Other federal government securities (short-term securities issued by individual government agencies or government-sponsored organizations such as Fannie Mae).
- Banker's acceptances (used to finance international commercial transactions).
- Repurchase agreements, or "repos" (ways of selling financial holdings for a day or two with a pledge to buy them back at a higher price).
- Eurodollar CDs (issued by the foreign branches of U.S. banks).
- Yankee CDs (issued by U.S. branches of foreign banks).
- Short-term municipal bonds issued by state and local governments (money-market mutual funds that invest exclusively in these pay tax-free earnings).
Short maturities help insulate the value of a money market portfolio from movements in interest rates. Prices of interest-paying investments such as these fall when rates rise, and vice versa -- the shorter the maturity, the smaller the move.
There are two ways individual investors typically participate in the money market, through FDIC-insured bank accounts, or through uninsured mutual funds. Lets take a closer look at each.
Money-market deposit accounts
Money-market deposit account (MMDA) offer federal insurance plus interest that's somewhere between a passbook account and a CD. Banks and thrifts like to boast about the higher rates paid by these accounts, but in fact they rarely compete very well with certificates and routinely lag money-market mutual funds.
MMDAs probably compete more directly with low-rate savings accounts and interest-paying checking accounts, except for all the strings attached: You can write a limited number of checks on the account and make a limited number of withdrawals; if you exceed the limit, you pay a penalty.
When shopping for money-market accounts you'll want to compare:
- Annual percentage yield.
- Minimum deposit.
- Minimum balance requirements.
- Check-writing limits.
- Fees and penalties.
If you compare MMDAs with money-market funds, the limits on liquidity and typically lower rates add up to a high premium to pay for federal deposit insurance.
Money funds generally pay more than deposit accounts, with no significant increase in risk.
The minimum initial investment usually ranges from $1,000 to $5,000, for which you get a slice of a portfolio containing a number of money market investments that you could never afford on your own.
One of the most attractive features of money-market funds is that you can redeem your shares anytime by writing a check drawn on your account. You pay no sales fees either buying or selling.
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The funds' managers, who decide which money-market instruments to buy, charge a modest management fee, on the order of 1% or so. All that makes the funds liquid, convenient and relatively economical to own.