The Highest Yielding "Safe" Investment Now - Tax Exempt Money Market Funds

by Xin Lu on 26 September 2008 8 comments

Last year I wrote an article about how I used my Vanguard Tax Exempt Money Market Fund as a high yield checkings account, and this week I suddenly got quite a few hits for that article.  So I wondered why that was and found that the yield for the tax exempt money market funds have shot up significantly.

The underlying investments for tax exempt money market funds are municipal short term debt also known as "munis".  These are short term bonds or debt notes  issued by local governments to build things like schools and libraries.  The money earned from these munis are exempt from all federal taxes and also the state taxes of the locale where it is issued.  Usually, the money market funds that invest in these short term debts have lower yields than their taxable counterparts since investors get a higher tax equivalent yield.  However, the current situation is quite unusual and the yields have turned upside down.  For example, the Vanguard California Tax-Exempt Money Market Fund's current yield is 4.66%, and that is nearly twice of the yield of the Vanguard Prime Money Market Fund.  Since the California Tax-Exempt Money Market Fund's returns are not subject to state or federal taxes, 4.66% is equivalent to a taxable rate of more than 7% for someone in the 28% federal and 9.3% state tax brackets.  A better deal is in the Vanguard Pennsylvania Tax-Exempt Money Market Fund, which has a yield of 5.44% and equates to a pre-tax yield of more than 8% for some Pennsylvanians.    Needless to say, these yields are extremely high for tax exempt money market funds.

Why is this happening? This situation  is so unusual that Vanguard actually wrote an entire article explaining it .  The basic gist of the article is that since credit is tightening, municipal bond issuers have found that they need to increase their yields to attract investors.  Since Vanguard simply follows the market, they are getting better yields. 

Are these investments safe?  Generally money market funds maintain their share values at $1.00 each, but recently we have seen a couple money market funds "break the buck" .  Even so, municipal debts are generally considered to be safe investments since they are backed by local governments and their tax bases.  Of course, local governments can go bankrupt so there is definitely a risk of default, but tax exempt money market funds generally have a portfolio of many different bonds from a collection of governments, so their risk is lower. 

Finally, money market yields change everyday so no one knows how long these high yields will last.  However, since money market funds are as liquid as cash, you can always move your money when the yields go down.  For now, I really cannot find another "safe" investment vehicle that pays as high as these funds. 
 
Disclosure:  I  own the Vanguard California Tax-Exempt Money Market Fund (VCTXX) and the Vanguard Prime Money Market Fund (VMMXX)

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Andrea Karim's picture

I wonder if I've lost so much money that it's too late to move everything. I'm afraid to even look at my IRA.

Guest's picture
Guest

I was looking for something just like this. Any ideas on the brokerage fees associated with these types of accounts?

Xin Lu's picture
Xin Lu

There is no fee at Vanguard or Fidelity to open a regular account I believe.  There are expense ratios on the funds and minimum investments.  The expense ratios on these funds are pretty low at Vanguard.

Guest's picture

I'm not a credit rating expert, but just wanted to reinforce your point, Xin, that the market is discounting muni bond issuers as being increasingly risky. Inversion of yields is interesting, but suspect. Most state governments are just as fiscally irresponsible as the federal good ol' boys, but with far less resources under their command.

Definitely a great suggestion and something to look into further!

Guest's picture
Guest

The muni market is in disarray, if you google it you will get discussions about the Auction Rate Securities which are Munis. There were all sorts of reports in the media this past year about being told this was as safe as cash and then when they need the money, they cannot get it out because the muni credit market is locked up. Certian funds (not Vanguard) were unable to redeem mutual fund shares either for periods as long as a month. The other side is munis depend on tax revenue and there will be shirtfalls soon

Risk and reward are supposed to coorelate, if you are getting a higher rate then you are presumably taking on more risk

Guest's picture
Joey

There is a high yield money market account that is available at http://www.unionfsb.com/ that pays 3.75%.

Guest's picture
Andys2i

Great suggestions and I just moved my cash reserves into the Vanguard Tax-Exempt Money Market fund (VMSXX) that is currently yielding 5.84% - far above money market averages and with an industry bottom 0.17% management expense ratio. If you're in the 25% tax bracket, the return on this fund is equivalent of a taxable 7.7% APY! Can't get that anywhere else in the market right now!

Guest's picture
Guest

Although Muni Bond Funds never made sense for a 401K or IRA, wondering if there would be any negatives in doing so now?