In addition to checking and savings deposits and CDs, banks often offer investments in mutual funds. While mutual funds are often used to invest in stocks and bonds, a major chunk of total assets is invested in money market funds.
At the end of November 2007, money market mutual funds had nearly $3.075 trillion in assets, or nearly 26 percent of the $12.076 trillion invested in all mutual funds, according to the Investment Company Institute (ICI), an industry group that represents mutual fund companies.
Unlike FDIC-insured deposits, money market funds are not federally insured investments. However, money market funds are the safest of all mutual fund categories and have a long history as stable investments that seek to maintain a constantnet asset value of $1 per share.
Since their share prices do not fluctuate the way prices of stock and bond funds do, and since they have an average maturity of less than 91 days, a money market fund's price is often stated in terms of its simple or compounded yield. Often, the yield is shown for a 7- or 30-day period, which reflects an annualized rate of return.
For example, a yield of 1.6 percent indicates that, on average, a money market fund generates $1.60 annually in income for each $100 invested. The Federal Reserve influences yields on money market funds through its use of monetary policy. From June 2004 through June 2006, the Fed raised short-term interest rates 13 times, leading to sharply higher money-market yields than those of a year earlier.
Money market funds are available as taxable or tax-exempt funds. Taxable money market funds invest in securities whose income is exempt from federal income taxes, including Treasury securities. Tax-exempt money market funds invest in short-term securities whose income is exempt from federal income taxes, such as bonds issued by state governments and municipalities.
Assets in taxable money market funds dwarf those held in tax-exempt funds. In part, this may be due to the relative scarcity of tax-exempt funds and also due to the fact that investors often keep money market funds for short periods of time before deploying those assets elsewhere. (Fund managers call this short-term strategy "fund-parking.")
To help you evaluate a tax-exempt money market fund, you may want to look at its taxable equivalent yield. A taxable-equivalent yield calculates the yield you would have to earn on a taxable investment that would match the yield you earn on a tax-exempt fund.
To calculate the taxable-equivalent yield:
Subtract your federal income tax rate from 100. For example, if you are in the 25% income tax bracket, the difference is 75. This figure is called your reciprocal-of-tax-bracket.
Divide the tax-exempt fund's yield by your reciprocal-of-tax-bracket. If the yield on a tax-exempt fund is 1.8 percent and your reciprocal-of-tax-bracket is 75, the taxable-equivalent yield is 2.40 percent.
In other words, you would have to earn a yield of at least 2.40 percent on a taxable money market fund to make the taxable fund more attractive than the tax-exempt fund.
If your tax-exempt fund is also exempt from state income taxes, subtract your combined income tax rate from 100. For example, if your federal and state income tax rates sum up to 40 percent of income, your combined reciprocal-of-tax-bracket is 60.
Using the same formula, a 1.8 percent yield on the current tax-exempt fund has a combined taxable-equivalent yield of 3 percent.