Money funds -- yields on the rise
By Bankrate.com

As with most fixed-income investments, money market mutual funds are seeing yields climb as the Federal Reserve gradually tightens short-term credit. Taxable money fund yields have inched upward. The highest-yielding funds, as rated by Bankrate.com, are pushing 1.50 percent. Bankrate ranks only funds that are stand-alone accounts. Funds that are limited to a group of people such as AARP, or that require the consumer to have more than one account, such as PayPal, are not included.

"Depending on the timing of the hikes, the market is still projecting the fed funds rate to be about 3.5 percent by year end 2005, so money funds should approach 3 percent by then. They're about 50 basis points, a half-percent, lower because of the expense ratio. If we get another soft patch or weakness, that 3.5 percent may be revised downward, but the numbers leading up to this had been on the strong side."

If for some reason the Fed stops the anticipated rate increases, competition among money funds may not be enough to keep yields rising, says Scott Berry, senior fund analyst at Morningstar.

"It'll be tough for them to go higher without the Fed continuing to raise interest rates. Some funds had been waiving expenses because of low interest rates and as rates rise they may remove those waivers and that would keep pressure on yields."

Money market mutual funds are often used by people with brokerage accounts as a short-term holding place for money that's waiting to be invested in stocks, bonds or mutual funds. In that environment there can be a tendency to pay little attention to the expense ratio, but for anyone using a money fund as a place to keep his or her emergency fund, the expense ratio is an important consideration. The cheaper, the better, says Berry.

"If you're going north of 0.75 percent, that's a lot to pay. Vanguard is tough to beat on costs at 0.30 percent and Fidelity charges 0.42 percent. If you look at expenses vs. yield there's a direct correlation. Look at the difference in expenses between Fidelity and Vanguard, it equals the yield difference."

Money market funds come in two flavors -- taxable and nontaxable. The yield on tax-free funds is lower than its taxable counterpart and generally, it's people in the upper-income tax brackets who benefit the most from tax-free funds. But there are times when folks in the lower brackets will find tax-free funds pay a higher tax-equivalent yield.

"Tax-free is a good deal at the moment, but look at what rate you're in, what state you're in, and monitor the yields," Crane advises. "Tax-free yields bounce around a lot and may look good one week but the next month they fall back down. Tax-free funds equal about 15 percent of the total money fund base and are driven almost completely by high-net-worth individuals."

Unlike money market accounts, money market funds are not FDIC insured. But they are regulated as to the investments they can hold and while some funds have lost money, no customer has because the fund companies "eat" the losses.

When it comes to yields, money funds are no competition for high yield money market accounts, many of which currently offer better than 2 percent. Nevertheless, money funds still have their fans, says Crane.

"For most investors who have less than $10,000, even if there's a full percent difference in yields, that's only $100 a year. It's not worth having a separate account. All their assets are at Schwab or Fidelity, they get one statement and the cash balance tends to sit there. Another reason is money funds give you more liquidity. Money market accounts limit you to six transactions per month."

For a historical perspective on taxable money funds, first created in 1971, the lowest average yield, according to IMoneyNet, was 0.51 percent in April 2004. The highest yield -- an annual average since that's all the data available from that time -- was a hefty 16.8 percent in 1981. The recent high was about 6 percent at the end of 2000.

PLUS: Calculate the tax-equivalent yield.