Money-Market Yields Struggle to Stay Positive

Poor grandma. You know the market's lost it when even the AARP Money Market Fund (AARXX) returns nothing, as it did one day last week, according to Lipper. If the Federal Reserve again cuts interest rates this week, don't be surprised to see yields slip into negative territory.

Money-market mutual funds are typically about as low risk as an investment can get. That's why many people use these funds, consisting primarily of U.S. Treasurys and other super-safe short-term debt, as a parking place for cash. But these aren't typical times. The benchmark federal-funds rate, the target the Fed sets on rates for overnight loans between member banks, is currently at 1%. Keep in mind that's a target. The effective rate, calculated daily, is now pushing 0%, the lowest it's been since the 1950s. Meanwhile, fearful investors hoping to preserve capital rather than grow it have been pouring into Treasury bills, pushing those yields into zero territory.

The result? Since yields on taxable money funds are closely tied to the Fed's benchmark rate and many money funds hold Treasurys, yields on hundreds of money funds are dangerously close to going negative.

If the Fed again cuts the already-low target for its benchmark rate when it meets this week, then watch out. "You're getting next to nothing right now and could get less [this] week," says Lipper analyst Jeff Tjornehoj.

It's a reminder of why buying only ultra-cheap money funds from established players is so important. The higher a fund's operating costs, a.k.a. expense ratio, the more likely your money fund will have a tough time keeping yields positive if the fed-funds rate falls further.

"If you're in a higher expense-ratio fund, expect yields to shrivel even further [if the Fed cuts rates]," says Christine Benz, Morningstar's director of personal finance, "and those are funds that would be more likely to have to shut down if yields went too low."

Big houses such as Fidelity and Vanguard can waive fund fees temporarily to avoid negative yields. But smaller fund shops might resort to charging other fees to make up for losses. Either way, yields could be at 0% for some time.

The good news is money funds are too important for the Fed to totally disregard them. Cutting the fed-funds target to 0.5% or below "would crush money-market mutual funds" and therefore isn't likely to happen, according to economic research firm Laffer Associates. But could the Fed drop its target to 0.75% on Tuesday afternoon when it wraps up a two-day meeting? Sure.

Bottom line: If you have cash in a money fund that you don't need to tap in the next couple of years, it wouldn't hurt to shop around for a high-yielding CD. But if you want the liquidity of money funds, at this point yield-chasing is secondary to just finding a stable place to park. When the markets start to improve, at least you'll know where your cash is and be ready to re-allocate it.

"You shouldn't time the money markets," says Pete Crane of money-market tracker Crane Data. "Unfortunately, what the Fed is giving you now stinks, because it's trying to push you into stocks and bonds."