Tax-Free Money Market Funds Chase Low Yields
Investors who’ve been flooding money market mutual funds with cash in recent months are challenging fund managers to find enough securities to absorb that wad.
The greatest challenge, by far, is faced by managers of tax-exempt muni money funds, which invest in short-term debt securities issued by states and municipalities.
An avalanche of cash into those funds helped push yields to 4 1/2-year lows in mid-February, as managers chased after scarce securities.
Yields have rebounded since, but they’re still so low that analysts question whether many investors in tax-free money funds are in the right place. They might do better in regular taxable money funds.
“Unless you’re in the highest tax brackets, you really shouldn’t be in tax-free money market funds,” said Peter Crane, editor of money-fund tracker IBC’s Money Report in Ashland, Mass.
The average seven-day compound yield on tax-free money funds nationwide fell to 2.01% (annualized) in the week ended Feb. 15, IBC said. That was the lowest since 1994.
As of last week the average seven-day yield had rebounded to 2.45%. But that was still below the 3.03% average yield at Dec. 31.
By contrast, the average seven-day yield on taxable money funds has slipped only from 4.64% at year-end to 4.47% now, IBC said.
Investors who own California-only tax-free money funds--which invest exclusively in securities issued by California and its municipalities--get a double tax exemption on the interest earned (federal and state).
But California fund yields have been below the already-low national average lately, IBC notes. Even with the double tax exemption, muni funds may not be worth it.
The downward pressure on short-term muni yields in general has occurred because there aren’t enough new note sales by states, cities and public agencies to satisfy the strong demand from money fund investors.
As fund managers bid aggressively, borrowers are able to mark down their yields. That puts fund managers in the curious position of praying for a slowdown in new money and new investors.
“The only thing you can do is pray you are one of the funds that doesn’t get new assets,” said Steven Shachat, who manages about $2.8 billion in money market funds for Lieber & Co. in Purchase, N.Y.
Tax-free muni money funds now hold about $200 billion in assets--about 14% of money market fund assets in total.
Even for an investor in the 36% federal marginal tax bracket--which begins at taxable income of $155,950 for marrieds filing jointly (and $128,100 for singles)--the 2.45% average tax-free money fund yield is the equivalent of earning just 3.83% in a taxable fund.
So with the average taxable fund yield at 4.47%, an investor in the 36% bracket would be better off in a taxable fund unless that taxable yield drops significantly--or unless the tax-free yield moves up significantly.
Investors in lower tax brackets have even less reason to be in muni money funds.
Overall, muni money market funds generate about 55% of the yield of their taxable brethren. That’s in sharp contrast to long-term munis, which now yield about 92% of taxable Treasury bonds.
Analysts say the shortage of new issues of muni notes and bills will remain acute because of a drop in short-term borrowing.
“There’s always going to be a shortage of short paper,” said George Friedlander, market strategist at Salomon Smith Barney. “Borrowers don’t need notes because their finances are in good shape. And because rates are still low, they’re willing to lock in borrowing long-term.”
Some of the largest annual note sales have been curtailed as states use pay-as-you-go spending from coffers swollen by tax receipts.
Texas last year cut its note sales by 45% to $1.6 billion while California cut its in half to $1.7 billion.
Managers said that has prompted them to scour the market for notes from smaller borrowers.
“Most of our luck now has been in smaller issues that don’t garner the same attention as the big Texas or California sales,” said Reid Hill, who manages about $1 billion in taxable and tax-exempt money market funds for Van Kampen Funds in Oakbrook Terrace, Ill. “We search for off-the-run names.”
Securities firms have tried to fill the gap in supply by creating so-called synthetic notes by buying long-term munis and repackaging them as securities that mature in as little as a day. Even those haven’t been able to keep up with demand lately.
To be sure, there are signs that the tide of money coming into tax-free funds may be starting to ebb. Investors withdrew more money than they invested in the last half of February.
“We expect outflows to continue as we approach April 15,” said Crane at IBC.
“These funds tend to be weighted to wealthy individuals and they tend to have much higher outflows than money market funds as a whole at tax time,” he added.
Of course after tax time, there may be record amounts of refunds to park somewhere.
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California Funds: A Sampling
Looking for a California tax-free municipal money market fund? Shop around. Yields differ dramatically, as this sampling of 15 major California funds shows. Shown are seven-day compound yields (annualized) and average portfolio maturities, as of last week. Note that some funds boast higher yields because they are waiving management fees, sometimes indefinitely.
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7-day Avg. Assets, compound maturity, Money market fund in millions yield in days USAA Tax Exempt Ca. $414.9 2.64% 35 Vanguard Ca. Tax-Exempt 2,032.8 2.56 47 Amer Century Ca. Muni. 177.0 2.48 13 Montgomery Ca. Tax-Free 271.1 2.46 51 Fidelity Spartan Ca. Muni. 1,229.4 2.45 42 Amer. Century Ca. Tax-Free 452.3 2.39 24 Fidelity Ca. Municipal 1,354.2 2.33 40 Dreyfus Ca. Tax-Exempt 199.6 2.28 39 Schwab Ca. Muni/Value Adv. 1,373.2 2.28 37 Nuveen Ca. Tax-Free 178.1 2.28 28 CMA Ca. Municipal 2,207.6 2.25 49 Smith Barney Muni Ca./A 2,160.6 2.24 46 Pacific Horizon Ca. T-E 556.9 2.24 31 Franklin Ca. Tax-Exempt 663.8 2.18 49 Stagecoach Ca. Tax-Free 2,256.3 2.13 39 Avg. national tax-free fund 2.45 40
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Source: IBC Financial Data
