What is a money market fund?
Money market funds are a cash-like investment that can be held inside stocks and shares ISAs, SIPPs, or general investment accounts.
They own a diversified basket of safe bonds that are due to mature soon, normally within a year, meaning that investors can earn an income on their cash with minimal risk.
Investors use them to park cash balances, but also earn a modest income inside a tax-friendly wrapper.
Types of money market funds
Fund industry trade body the Investment Association (IA) categorises money market funds into two buckets: short term and standard term funds.
Short-term funds are lower risk. Fund managers try to ensure the highest possible level of safety by keeping very short duration bonds and high-quality bonds in the portfolio.
Standard money market funds generally deliver slightly higher returns by owning bonds that have slightly longer maturity dates.
Why invest in money market funds?
They are a safe place to hold your cash, without having to move it out of an investment account and into a traditional bank. This means the money is kept within the tax-friendly ISA and SIPP wrappers.
Money market funds will rarely pay interest as high as a savings account, but they do offer a return on your cash, so they are more effective than just keeping money in cash which will be eroded more quickly by inflation. This return increases as interest rates rise.
Money market funds tend to be cheap and easy to trade, making them a cost-effective tool for managing cash.
Advantages of a money market fund
- Very low risk, with the portfolio likely to at least hold its value and also pay out a modest income.
- Diversified and highly liquid, meaning investors are not exposed to a single bond failing and can withdraw their money easily.
- Can be held in a tax-friendly wrapper, like an ISA or SIPP.
Disadvantages of a money market Fund
- Investments may fall in value, unlike savings accounts.
- Not suitable for growing savings over the long term as yields are typically below inflation.
- Sensitive to interest rate fluctuations, with lower rates leading to lower yields. Yields rise when interest rates rise.
- The Bank of England warns that in times of market panic and a rush to cash, there may be liquidity issues in money market funds.
Are money market funds safe?
There is no guarantee that the value of a fund will not fall, but they are managed by professional fund managers who aim to maintain their value.
A money market fund is still an investment, even though it is low risk, and could go down in value. Bond prices can fluctuate over time, and it is possible that a company may not be able to pay back its debt.
However, money market funds are diversified across many financial instruments and providers, so the risk of losing your money is low. They own high-quality bonds that are due to mature soon, meaning they are highly unlikely to default or struggle to pay their interest obligations.
Why are cash returns on the rise?
The Bank of England reduced interest rates to historic lows, first during the financial crisis of 2008-09, then at the start of the pandemic in 2020.
In 2009, the base rate was reduced to below 2% for the first time since the Bank of England was created in 1694. In March 2020, rates were cut to a record low of 0.1% in response to Covid-19.
However, in December 2021 the Bank of England began to rapidly increase interest rates to tackle inflation. This had the effect of increasing returns from cash.
What will happen if interest rates keep rising?
As interest rates rise, it is likely that money market funds and some longer-term cash savings accounts will begin to offer more attractive rates of interest.
Should retail investors use money market funds?
When interest rates are near historical low levels, most money market funds show disappointing returns and do not match interest rates on some of the best fixed-interest rate savings accounts.
However, money market funds typically become more competitive as interest rates rise.
What is the rate of return on a money market mutual fund?
Yields on money market funds have risen in 2022 as Bank of England interest rates increased. The yield figure on a fund reflects the amount of income the fund is generating from the underlying investments.
The value of your investments may go down as well as up. You may not get back all the money that you invest. If you are unsure about the suitability of an investment product or service, you should seek advice from an authorised financial advisor.