Money Market Funds

What are Money Market Funds?

In a world of super-low interest rates, many cash-heavy investors move their funds over to money market fund accounts. Money market funds returns are decent, and the accounts are safe. Money market funds are savings vehicles for individuals who want to park their cash in investments without losing value and paying a competitive interest rate. The demand for money market funds has increased in recent years, partly due to bank reserves and government securities management applications. Many investors have also turned to money market funds for their owners' stability and security.

Who should invest in Money Market Funds?

Money market funds are designed for investors who want to preserve their principal and earn some interest in it. They may be appropriate for investors who:

  • Want to invest with minimal risk and high liquidity.
  • Have excess cash that they need to hold temporarily but don't want to park it in a low-yielding account like a checking or savings account.
  • Want to save up for a large purchase or expense, such as paying college tuition or buying a house.

A money market fund is a safe place to park cash. These funds are known for safety, liquidity, and relative stability compared with other investments.

The following types of investors will benefit from money market funds:

  • Investors who want to keep their risk profile low should invest in money market funds. The chance of losing money is minimal as the investments are made in short term instruments that are highly liquid.
  • Investors who want stability and regular income should also invest in money market funds since they are highly liquid and provide stable returns. Money market funds can offer better rates than fixed deposits, making them more attractive for investors who want decent returns without taking any risks.
  • Any individual looking to park his idle cash can also consider investing in money market funds since they offer high liquidity and generate good money market fund returns.

Taxability of Money Market Funds

Money market funds are treated as debt mutual funds and taxed accordingly. The capital gains tax is levied at income tax slab rates if the investments in money market funds were held for less than three years (short-term capital gains).

If the investment was held for more than three years (long-term capital gains), a 20 per cent tax with indexation is charged. Indexation helps reduce your tax liability by adjusting your cost inflation index (CII).

The tax treatment for best money market funds will depend on how long the investor has held the fund and whether the fund invests in corporate or federal debt instruments.

Money market funds return generated would be added to your gross income and taxed at your applicable slab rate. In addition, interest earned on debt mutual funds qualifies for indexation benefit. Indexation means that inflation is taken into account while computing long term capital gains (LTCG)

Risks involved with Money Market Funds

The most significant risk of money market funds is that their value can decrease, just like other investment securities. As with any investment, there are risks involved with money market funds. The primary risks include:

  • Interest rate risk: Money market funds are subject to interest rate risk. If interest rates increase, the value of the fund declines, and vice versa. Interest rate risk is usually greater when interest rates rise rather than fall.
  • Credit risk: Money market funds invest in debt securities such as commercial paper, bank CDs, and Treasury bills. These investments carry varying degrees of credit risk depending on the quality of the issuer and its ability to pay back principal and interest when due. The fund’s investment adviser attempts to diversify the credit risk among different issuers by investing in various types of debt instruments with varying maturities and credit ratings, but this may not always be successful.
  • Liquidity Risk: Money market funds are highly liquid, but some investments may face liquidity issues if investors start withdrawing their money en masse or if the issuer faces liquidity problems. If you face liquidity issues, you may have to sell your investment at a loss to raise cash.

Advantages of Money Market Funds

The primary objective of money market funds is to maintain liquidity and safety while offering higher interest than a savings account. Money market funds have advantages such as:

·       Professional Management: Fund managers who care for your investments professionally manage these funds. They are experts and are paid to manage your money.

·       Diversification: When you invest in a money market fund, your money is diversified across various investment options. This helps in reducing the risk associated with the investments.

·       Liquidity: Money market funds are liquid as they invest in short-term securities, which can be converted into cash quickly. You can withdraw your investment at any time from these funds by placing a redemption request with the fund house.

·       Higher Returns than Bank Accounts: When you compare interest rates on bank accounts with that offered by money market funds, you will find that these funds provide higher returns than bank accounts.