Fed’s Liquidity Unwinding Won’t Boost Money Funds’ Returns

The unwinding of the Federal Reserve's liquidity programs is unlikely to boost the sickly yields on tax-free money market funds, participants say.

While rates on many financial instruments may respond to the reversal of the Fed's "quantitative easing," rates on money funds are moored fairly tightly to the federal funds rate itself - which has been held below 0.25% for more than a year.

That means that even as the broader fixed-income market braces for higher rates, money market funds are unlikely to offer investors much better than zero returns for, as the Fed put it again yesterday, "an extended period."

Investors have ferried their cash out of money market funds steadily for more than a year. The tax-free money fund industry's assets have shriveled to $373.4 billion from $489.3 billion at the end of 2008, according to the Investment Company Institute.

Many market participants blame low yields.

Tax-free money funds, which invest in variable-rate debt obligations and other short-term securities issued by municipalities, yield a record-low 0.02%, according to iMoneyNet. Investors can only stomach these returns for so long before looking for better yields elsewhere.

Why are rates so low?

Mary Jo Ochson, head of tax-free money funds at Federated Investors, said money market rates are basically a function of the federal funds rate - the rate at which banks lend to one another overnight.

The Fed's target for that rate sets an anchor for other low- or no-risk rates like the Treasury bill or the London Interbank Offered Rate, because they all compete for money looking for a safe place to park.

"Tax-exempt money market funds will respond to an increase in fed funds rates, when they do increase," Ochson said.

Notice what she did not say: that the raising of the discount rate - or the expiration of the Fed's program to buy mortgage-backed securities, or the unwinding of any of the other extraordinary monetary stimulus measures beyond the federal funds rate itself - will have much influence on the yields on products purchased by tax-free money funds.

Michael Sebesta, director of liquidity management at StableRiver Capital Management, a sub-advisor to certain RidgeWorth Investments, said the withdrawal of quantitative easing may induce a slight bump in money market yields - perhaps 10 or 15 basis points.

The real jump will come with the federal funds rate, he said.

The more muted increase from the unwinding of quantitative easing likely will not be enough to reverse the exodus away from money funds, Sebesta said.

"It's going to take a much bigger move to mitigate that outflow," he said. "Money fund yields are just so, so low that it's going to take a more significant change to get people to put money back into the money fund complex."

Christian Hviid, chief market strategist at Genworth Financial Asset Management, said even when the federal funds rate begins to ascend, money funds may have trouble commanding much cash.

Products with longer maturities and slight credit risk yield so much more than cash now that it may be advantageous to stay a little bit further out on the curve even after money market rates have risen, according to Hviid.

The value lost on a short-term bond from an increase in interest rates would still be less than the value surrendered from switching to such low yields on cash, he said.