Interest Rates Are Rising, Time to Think about “Float” Again

Time to Think about Float Again
The Crash of 2007 to 2010 took even the greatest of the money market funds down.  It taught us that due diligence and liquidity matter.

Those who survived were by in large chastened by a near death experience.  They now long for the 5 to 10% of total revenues that “float” and higher interest rates brought them.  Rates are rising slowly.  It’s time to start watching the signs and learning about where to invest funds.  You will find that the environment has changed.

What happened to the markets as a result of the crash?
The Fed got serious about regulating shaking banks and mortgage companies who used “boiler rooms” to sell poor quality paper to money market funds.  The also dropped interest rates to zero by buying government paper and mortgages, and we know that as interest rates fall, the price of fixed rate paper goes up.  High grade paper is now that unsustainable high prices, which will drop very quickly when the Fed starts to both sell their fixed rate holdings and push rates high enough to encourage investors to come back into the market.  Today those investors, like you, have mountains of cash sitting on the side lines waiting to get a decent return.

What happened to money market funds as a result of the crash?
Many went out of business.  Some drove away customers who had to wait months to get their funds back.  Some left because regulators said they needed more capital and better business practices if they wanted to play again.  The industry changed.  Prior to the crash almost all money market funds promised immediate payment on demand to return $1 for each $1 invested.  When the crash came many found that when they went to sell fixed income paper, they could not get a dollar for it.  Market prices had fallen and they could only get 90 to 95 cents on the dollar.  The difference wiped out their capital, and money market share holders lost money.  If the money they had invested was tax money, for example, they had to make up the difference by using their own capital and lines of credit.  President Bush stepped in and said that the Government would “insure” that no money fund would fail.  His action saved the market.

The surviving money funds, with a push form their regulators, changed the way they did business.  Today you can invest in money funds which invest only in government paper.  From them, they promise that they will pay back a $1 back for each $1 invested.  Because they deal only in high grade government paper, investor will get paid a lower return, but get better liquidity, lower risk, and lower management fees than money funds which do not promise a $1 for $1 exchange value.  A new group of money market funds will reprice the net asset value (NAV) of the portfolio of fixed instruments they hold, at least daily, much like equity and bond mutual funds do today.  Investors in these money funds will be subject directly to moves in the interest rates and general bond markets.  If rates go down, they make money.  If rates go up, they will lose money.  If you have a tax account with $10 million which is invested in an NAV money market fund on the day the Fed raises interest rates 25 basis points (as promised), you lose.  If interest rates today are 2% below normal, and the markets “revert to the mean”, you are on track to lose much more.  Your losses will come out of your cash flow, working capital, savings…

Some of you will make that bet, no matter what I say.  Most, I hope, will act more prudently.  The markets are stacked against the speculators at this time.  If rates stay low, you will earn nothing from your float but the meager “compensating balance rate” your bank will pay you to buy down your bank service charges.  If rates go up your income goes up (depending on the credit quality of the paper you are buying, and it’s duration), but the value of your position will go down in an NAV fund.

You should avoid this risk by using highly rated and ethical money market funds; managed by experienced managers with good track records who will return to you $1 each invested $1.

It’s time to do your homework, to select strong and well managed money market funds, and to start moving funds out of very low returns on your banks compensating balance earnings credit, and into qualified money market funds which will return all your principle at your request for liquidation.  Your investment advisor can help you on the phone or online.

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