New rules to lower already low yields on money market funds

06/01/2010 10:30 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Talk about terrible timing. New rules from the Securities & Exchange Commission that require money market funds to hold at least 10% of their assets in cash or in highly liquid investments such as U.S Treasuries that can be converted to cash in one day will reduce already miniscule returns from these funds.

Another rule requires funds to hold at least 30% of their assets in cash, in Treasuries, in other government securities with remaining maturities of 60 days or less, or in other securities that can be converted into cash in a week or less.

A third rule reduces the limit on the percentage of illiquid securities that a fund may hold to 5% from 10% and defines illiquid as any security that cannot be sold within seven days at its carrying value.

All in all the new rules will reduce money market fund yields that are now barely above 0%. The highest seven-day yield I could find for a money market fund on Friday May 28 was just 0.14%.

But the biggest effect of the new rules, which went into force on May 28, may be on the ability of troubled banks to raise money in the short-term commercial paper market.

Money market funds are, in normal times, big buyers of the short-term debt that banks use to fund their loans. With money market funds now required to hold more of their assets in safe debt that will reduce the demand for any bank debt that comes with the slightest whiff of risk even further. And it’s not like these funds were rushing to load up on risky paper before the rules went into force.

The effect will be to raise demand and bid up prices for commercial paper from solid banks—which will reduce the cost of funding for these banks and reduce the yield that money market funds get from holding this debt—and to force down the prices of commercial paper from risky banks—which will increase the cost of funding for these banks or shut them out of the short-term debt market completely.

The rules are intended to head off any run on a money market fund in the event of another financial crisis.

Money market funds currently hold $2.8 trillion in assets. That’s well below their peak assets of $3.8 trillion in January 2009. Money market fund assets were last this low in September 2007.

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