Ultimate Guide to Money Market Investing

Ultimate Guide to Money Market Investing

Chances are you've heard the term before, but what exactly is the money market? It is the organized exchange on which participants can lend and borrow large quantities of money for a period of one year or less. While it is an extremely efficient arena for businesses, governments, banks, and other large institutions to transact funds, the money market also provides an important service to individuals who want to invest smaller quantities while savoring the finest liquidity and safety found anywhere.

Purposes of the Money Market

Individuals invest in the money market for much the same reason that a business or government lends or borrows funds in the money market: Sometimes having funds does not coincide with the need for them.

For example, if you discover you have a certain quantity of money that you do not immediately need, you may choose to invest those funds temporarily until you need them to make some longer-term investments or a purchase. If you opt to hold these funds in cash, the opportunity cost you incur is the interest you could have received by investing your funds.

The main attributes that attract an investor to short-term money market instruments are superior safety and liquidity. Money market instruments have maturities that range from one day to one year, although they are most often three months or less.

Because these investments are associated with enormous and actively traded secondary markets, you can almost always sell them prior to maturity, albeit at the price of forgoing the interest you would have gained by holding them until maturity.

The secondary money market has no centralized location. The closest thing the money market has to a physical presence is an arbitrary association with the city of New York, even though the money market is accessible from anywhere by telephone or internet. Most individual investors participate in the money market with the assistance—and experience—of their financial advisor, accountant, or banking institution.

Types of Money Market Instruments

Money Market Instruments: Meaning, Types & Benefits

A large number of financial instruments have been devised for the purposes of short-term lending and financing. Many of these money market instruments are quite specialized, and they are typically transacted only by those with intimate knowledge of the money market, such as banks and large financial institutions.

Some examples of these specialized instruments are federal funds, the discount window, negotiable certificates of deposit (NCDs), eurodollar time deposits, repurchase agreements, government-sponsored enterprise securities, shares in money market instruments, futures contracts, futures options, and swaps.

Aside from these specialized instruments on the money market are the investment vehicles with which individual investors will be more familiar, such as short-term investment pools (STIPs) and money market mutual funds, Treasury bills, short-term municipal securities, commercial paper, and bankers' acceptances.

Short-Term Investment Pools (STIPs)

Short-term investment pools (STIPs) include money market mutual funds, local government investment pools, and short-term investment funds of bank trust divisions. All STIPs are sold as shares in very large portfolios of money market instruments, which may include any or all of the money market instruments mentioned above.

In other words, STIPs are a convenient means of cumulating various money market products into one product, just as an equity or fixed income mutual fund combines together a variety of securities, bonds, and so forth.

STIPs make specialized money market instruments accessible to individual investors without requiring intimate knowledge of the numerous instruments contained within the pool. STIPs also mitigate the large minimum investment quantities required to purchase most money market instruments, which generally equal or exceed $100,000.

Of the three primary categories of STIPs, money market mutual funds are the most accessible to individuals. These funds are offered by brokerage companies and mutual fund firms, which sell shares in these funds to their individual, corporate and institutional investors. Short-term investment funds are administered by bank trust divisions for their numerous trust accounts.

Local government investment pools are established by state governments on behalf of their local governments, permitting investors to purchase shares of local government investment funds.

Money Market Mutual Funds

Money market mutual funds: Why should you invest in them for long term  wealth creation? | Mint

Money market mutual funds are further divided into two categories—taxable funds and tax-exempt funds. Taxable funds place investments in securities such as Treasury bills and commercial papers that pay interest income subject to federal taxation once it is paid to the fund purchaser.

Tax-exempt funds invest in securities issued by state and local administrations that are exempt from federal taxation. These two categories of money market mutual funds provide distinct patterns of growth, each of which attracts different types of investors.

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Treasury Bills

Treasury bills—commonly known as T-bills—are short-term securities issued by the U.S. Treasury on a regular basis to refinance earlier T-bill issues reaching maturity and to help finance federal government deficits.

Due to their short-term maturities, T-bills have the largest trading volume and liquidity, with nearly $300 billion of notional value issued by the Fed as of October 2022. In addition to scheduling regular sales of T-Bills, the Treasury also sells instruments called cash management bills on an irregular basis, by reopening the sales of bills that mature on the same date as an outstanding issue of bills.

When T-bills were initially devised, they were assigned three-month maturities exclusively. Bills with six-month and one-year maturities were subsequently added. Three-month and six-month bills sell in the regular weekly auctions, and another bill auction takes place every four weeks for the sale of one-year bills.

T-bills are sold through the commercial book-entry system to large investors and institutions, which then distribute those bills to their own customers, which may include individual investors. An alternative is Treasury Direct, which is operated as a non-competitive holding system designed for small investors who intend to retain their securities until maturity.

Individual vendors on Treasury Direct have their ownership recorded directly in book-entry accounts at the Department of the Treasury. If an investor purchases T-bills through the Treasury Direct system and intends to sell them prior to maturity, they must transfer them to the commercial book-entry system.

The transfer can be arranged only through a depository institution that holds an account at a Federal Reserve Bank—the individual making the transfer is required to pay pertinent transfer fees.

Money Market Accounts

What Is a Money Market Account? Pros and Cons in 2019 - TheStreet

We can't write about the money market without devoting a little time to money market accounts. These are deposit accounts, just like checking and traditional savings accounts that are insured by the Federal Deposit Insurance Corporation (FDIC), and are different from money market funds.

They may grant the account holder some checking account-like privileges, such as the ability to write checks and/or debit card transactions. But they function like a savings account with a minimum balance requirement and certain restrictions.

As part of Regulation D, the federal government restricted the number of debit transactions for this kind of account to six per month—anything above that incurred a charge. During 2020, amid the pandemic, the restriction was withdrawn, with no date set for setting the limit back in place. However, some institutions may still limit the number of monthly withdrawals.

Account-holders of money market accounts also earn interest. Because many accounts have a minimum balance requirement, the return is usually higher than a conventional savings account. Money market accounts are generally secure, low-risk investments. Institutions offer higher interest rates because they use the funds in money market accounts to invest in short-term assets with short-term maturities, as indicated above.

Why Is It Called the Money Market?

The money market refers to its ability to exchange money on very brief notices. The investments in this market are considered currency equivalents and very liquid.

Can Money Market Accounts Lose Money?

Yes, money market accounts can lose money. Notably, commercial paper, which includes foreign currency certificates of deposit (CDs) and corporate debt.

Are There Downsides to Money Market Accounts?

Yes, there are some drawbacks to investing in money market accounts, including the fact that certain money market investments are not covered by Federal Deposit Insurance Corporation (FDIC) insurance. As well, the other drawbacks include the lower returns compared to other investments.

The Bottom Line

When an individual investor develops a portfolio of financial instruments and securities, they typically allocate a certain percentage of funds towards the safest and most liquid vehicle available: Cash. This cash component may remain in their investment account in solely liquid funds, just as it would if deposited into a bank savings or checking account. However, investors are much better off placing the cash component of their portfolios into the money market, which offers interest income while still retaining the safety and liquidity of cash.

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