What Are Money Market Funds?

What are money market funds?

That's a question all risk-averse savers sitting on a savings account with its meager returns, or on a CD with its withdrawal penalties, should be asking themselves if they're looking for a liquid investment with better returns.

In such a low-interest-rate environment, it can be difficult to reconcile both of these financial goals. And while money market funds and money market investments are also subject to lower interest rates, they are at least higher than those you'll receive in an abysmally low-interest-bearing savings account.

You see, money markets are comprised of highly liquid, short-term, low-risk securities that the U.S. government and large, stable firms use to finance themselves. At the same time, large companies warehouse cash holdings in them, while insurance companies and pension funds use them as a source to draw upon when payouts come due.

Money markets have existed for a long time as a way for large companies to finance themselves in the short term and for the U.S. government to meet funding needs as it awaits tax revenue.

But they didn't gain popularity until the 1970s. In 1971, the first money market fund, the "Reserve Fund," was started up by Bruce R. Bent and Henry B.R. Brown.

As 1970s-era stagflation began to ramp up and U.S. Federal Reserve chairman Paul Volcker pushed interest rates up over 20%, investors pulled out of traditional savings accounts, which were constrained by Regulation Q of the Glass-Steagall Act in the amount of interest they could pay on deposits, and into higher-interest-bearing money market funds.

But what are money markets comprised of and who are the big players in this huge market?

Here's our look...

What Are Money Markets?

As we mentioned earlier, money markets are comprised of highly liquid, short-term securities. They are, for the most part, discounted securities. This means that they don't pay interest, but rather allow an investor to buy a certain security at a price lower than what they are paid back at maturity.

The main players in the money market include the U.S. Treasury, the U.S. Federal Reserve, banks, and big corporations, as well insurance companies and pension funds.

The U.S. Treasury, for example, sells short-term notes to meet funding needs in the absence of tax receipts, which the government doesn't always receive in time to make expenditures.

The U.S. Treasury provides treasury securities of 21-, 91-, and 182-day maturities on a discounted basis.

The Fed is a huge seller of government securities in the secondary market when it attempts to push up interest rates, providing further government securities to the money markets.

what are money market fundsBig corporations also provide a big supply of funds for the money market in the issuance of commercial paper. Commercial paper is an unsecured promissory note issued by only the most credit-worthy of big companies, maturing in about 270 days.

The money markets are also comprised of repurchase agreements - "repos," where companies enter agreements to repurchase securities at a later date. Repo terms are generally no longer than four days, though sometimes they can extend as long as three months.

These and other short-term securities, shown in the accompanying table, comprise the supply for the money market. The demand comes from the Fed - which purchases U.S. Treasuries to lower interest rates - as well as insurance companies and pension funds looking for liquid investments that they can cash out to meet any payouts.

Companies often also warehouse their cash in money markets as a safe way to generate returns on surplus funds.

All of these securities in the money market are actively traded on the secondary market. The only problem is that these funds are traded in wholesale markets as well. Transactions can be in the many millions of dollars, which shuts out the ordinary investor.

That's where money market funds and accounts come into play.

What Are Money Market Funds?

The day-to-day financing of large corporations and the U.S. government does not involve individual investors. Money market funds are traded in blocks too large for small investors.

But smaller investors can get in on the money markets in two ways.

The first is through money market mutual funds. Fund managers pool together money market assets. They offer the safe, low-risk qualities of money market securities, but like all mutual funds, they do incur expenses.

Then there are money market accounts. Financial institutions offer these as interest-bearing savings accounts. However, the rates are typically a bit higher. They are usually lower than CDs, but you can write checks against them without having to incur penalties.

The Bottom Line: Money markets are where the government and large companies obtain short-term funding. This creates a highly liquid, low-risk market of short-term securities that big companies use to warehouse their surplus funds, and pension and insurance funds put their money in to meet payouts. Individual investors would be shut out from this market were it not for the money market mutual funds and accounts offered to them by financial institutions. Understanding exactly what money markets are is important for any investor who wants a safe place to put his or her money and to earn a little extra return than a simple savings account.

Jim Bach is an Associate Editor at Money Morning. You can follow him on Twitter @JimBach22.

More on Mutual Funds: Interest rate volatility is likely to be the norm for a while now, but a solid mutual fund investing strategy will preserve capital and protect against these potential wild rate swings...