Is Money Market Insurance Needed?

Two prominent mutual fund companies are planning to start insuring their money market portfolios against default--raising questions of whether they’re fixing something that isn’t broken.

Money funds, after all, have been a safe way for investors to capture yields on short-term debt instruments for more than 20 years. The funds are not federally insured like bank deposits, but for the most part they have not needed such protection. That’s because they invest in things like Treasury bills, certificates of deposit and corporate IOUs maturing in a matter of days, weeks or months.

The short-term nature of these holdings makes them highly secure. The funds also hold large amounts of such paper, and it is difficult to imagine a significant number of defaults happening all at once.

Only one money fund has ever allowed itself to decline in value, and it was a small portfolio designed for institutional shareholders that slipped modestly in price during the volatile interest rate climate of 1994. However, fund families occasionally have stepped in with their own cash to ensure that their money market portfolios didn’t fall below $1 a share.

The new proposals, from the Putnam and Fidelity fund groups, would provide a limited amount of coverage against default risk--the failure by an issuer to pay principal or interest when due.

“We anticipate that this type of insurance will become common practice for large firms in the industry,” says Robert Lucey, senior managing director at Putnam in Boston.

But the protection would not apply to market losses that resulted from spiking interest rates, backfiring trading strategies or other land mines.

Also, the insurance coverage proposed by Fidelity and Putnam would be limited to a modest dollar amount.

“It would probably provide protection from an isolated event,” says Peter Crane, editor of IBC’s Money Fund Report in Ashland, Mass. “But if there was a recession and a series of defaults occurred, the insurance wouldn’t cut it.”

Putnam plans to pay an independent insurer for $30 million in yearly coverage on its five money funds, which count $2.3 billion in combined assets. Fidelity, which has $80 billion in money fund assets, wants to set up its own insurance unit to provide $100 million in yearly coverage.

“It would be a modest amount of insurance against defaults only, which are rare,” says Robyn Tice, a Fidelity spokeswoman.

Although the coverage in both cases would be limited, so would the probable costs. Fidelity predicts its shareholders would see their expenses rise, and yields drop, by only 5 to 10 cents for each $1,000 investment. Putnam figures its shareholders would pay 20 cents for each $1,000.

Fidelity is awaiting approval from the Securities and Exchange Commission to establish its insurance unit, and Putnam says it already has arranged for third-party coverage, which will start within a few weeks.

The firms do not plan to tout insurance coverage in their marketing campaigns. “It could be misleading to do so, since the insurance is limited to one specific type of risk,” says Tice.

And both firms say there’s nothing on the current economic horizon that leads them to believe that such coverage will be needed any time soon.

“The time you want to do this is when there are no rumblings,” says A. Michael Lipper, head of fund monitor Lipper Analytical Services in Summit, N.J.

Crane does not think insurance is necessary since a better alternative is already available: money funds that hold nothing but Treasury bills or other short-term government IOUs. Such investments, which are fully insulated against default risk, have captured about 23% of total retail assets in money market funds, he says.

But the proposals could help investors better understand the risks inherent in money market funds, however slight. In particular, they could underscore that there’s no implied liability on the part of fund companies to subsidize losses, as they have occasionally done in the past.

“There’s a perception that if a money fund drops below $1 a share, the management company will buy [the defaulted investment] or put in cash so that investors are protected,” says Lipper.

But he calls this a “dangerous perception” because it means shareholders are expecting something of fund companies for which they are not collecting insurance premiums, and for which they are not legally obligated.