October 22, 2014

Money Markets & Money Market Rates

Understanding Money Markets

Money Markets are oftentimes confused with bonds, which is a type of fixed income security. They are both very conservative ways of investing. However, the difference comes into play when dealing with the length of time it takes for the security to mature. Bonds are more long-term debt securities while money markets are considered more short-term due to the fact that they mature in less than twelve months. Because of the short-term maturity of money market investments, they are coined as “cash investments.”

Money MarketMoney markets are a conservative way to invest your money, great for when you need a place to save to pay off mortgage rates and auto loans. They are the equivalent of an IOU, and can be invested in the government, banks, or companies. As with many short-term, conservative ways of investing, money market securities do not offer as high of returns on the initial investment. If you’re looking for something that can provide higher profits, you will be looking at other investments that are more volatile and risky, such as the stock market.

But don’t confuse the two–money market securities and stock market securities are two different kinds of investments–and have different risks associated with them. When you purchase a stock, you will oftentimes work through brokerages and trade in stocks with both high and low denominations. Money markets, on the other hand, are typically traded in high denominations to ensure low risk, and are controlled in the dealer market, meaning the company handles the trade of the securities, not a broker. Since money market securities are more conservative and short-term, they are also not purchased and traded as much as stocks.

Many investors will access money market securities through a money market bank account or money market mutual funds. What happens in these situations is that numerous individuals and investors are putting their investment funds into a financial institution which then purchases these securities and investments on behalf of their money market contributors. If you want to have more control over your money market investments, you would likely prefer treasury bills instead.

Money markets can be confusing if you’re not sure of all the different ways to utilize them. Let’s go through the various ways an individual can invest in a money market security and enjoy a conservative way to invest.

Treasury Bills

One type of money market security that investors can utilize are treasury bills. These are essentially government-issued investments, and are often called “T-bills.” Treasury bills allow the United States government to utilize money invested by citizens of the country.

Treasury bills are investments that mature no longer than one year, making them a safe, conservative short-term investment. Similar to certificates of deposits (which we will discuss further later on in this article), they are issued in increments of ninety days, six months, and twelve month maturities. Treasury bills have a specific face value. They are purchased at less than their face value, but are paid as such once they have matured. The investment that you gain from treasury bills is the difference that you earn between the purchase price and the maturity value.

As easy as the maturity process is for a treasury bill, they are a little more complicated to obtain. Unlike other investment opportunities such as bonds and CDs, you cannot just walk into your local financial institution and obtain them. Treasury bills require a bidding process in which numerous investors will be competitively bidding on a particular value of treasury bills. There are other ways that are non-competitive, but the general idea is that you are bidding on the return that you want to receive on the purchase price of the treasury bill. You may not get what you bid for, so keep this in mind when considering treasury bills as a way to invest your funds.

Treasury bills are loved for their simplicity and their accessibility. They are sold in lower denominations, so even if you have only a thousand or five thousand dollars to invest, you can enjoy the short-term, conservative benefits of purchasing a treasury bill. Treasury bills are extremely low risk due to the fact that they are fully backed by the government, and they are exempt from taxes–both state and local.

As simple as they are, the pitfall of a treasury bill is the fact that they will not make you “rich quick.” They are low-risk and conservative investment opportunities, and other money market securities will offer you a higher rate of return, as well as a long-term investment if that is what you are looking for. Additionally, as with other investments, if you cash them out before they mature, you may take a hit on your initial investment.

Certificates of Deposit

Certificates of deposit, also referred to as CDs, are bank-issued money market investments. These investments can be purchased at commercial banks and financial institutions. They can be either short-term or long-term investments, ranging in maturity of anywhere from three months to up to five years. Certificates of deposit are also great for individuals that may not have a lot of money to invest, as they can be purchased in a variety of denominations. Unlike keeping your money in high interest savings accounts or a checking account, you will be unable to access the funds while it is tied up in the certificate of deposit.

Certificates of DepositsSimilar to a treasury bill, CDs are low-risk and conservative, but oftentimes have higher yields because of the slim chance that a bank were to default or go under. The more risk you take with an investment, the greater likelihood for a better interest rate and financial yield. However, CDs are still considered extremely safe investments, both for short-term and long-term use. Even though most banks offer CDs, the interest rates in which they earn are oftentimes rarely in competition, so it is a smart idea to ensure you shop around at different financial institutions before purchasing a CD. Additionally, banks are FDIC (Federal Deposit Insurance Corporation) insured by the government, so your investment is at least backed with a $100,000 guarantee.

There is one important part about CDs that you should take note of, and that is to pay close attention to the APR (annual percentage rate) and the APY (annual percentage yield). These are two different ways of earning interest on your CD. APR refers to interest that is accumulated in just one year, while APY is interest that is accumulated over several years while including compounding interest.

Here’s how it works: if you have a five year CD that pays based on an APR, you will just receive that percentage based on what you invested. However, if you have a five year CD that pays based of an APY, then you will have the interest accumulated each year ADDED and figured into the following year’s interest. Instead of just earning on what you paid in, you will also earn based off the interest accumulating each year as well. It may not seem like a big deal, but when you are investing thousands of dollars, the compounding interest can add up greatly over a period of time.

CDs have their benefits: they are safe, conservative investments and allow you to know how much you will earn when you purchase them. CDs are at a disadvantage because of the low amount of interest they will earn compared to other money market securities, and your money is not accessible during the maturity time (unless you are willing to take a large penalty for paying it out early). So just make sure you aren’t putting away money that you actually need to pay things like monthly bills and home mortgages.

Commercial Paper

Commercial PaperCommercial papers are short-term maturity loans issued through a large corporation that are unsecured. They are typically discounted but are competitive with current money market interest rates. When we talk of short-term with commercial papers, we are talking about no longer than nine months, with many being more in the one to two month maturity range. These short-term money market investments offer a short-term way of investing one’s money. They are low risk, as commercial papers are generally only offered from companies with great financial standing and credit worthiness. Companies defaulting on a commercial paper investment is almost unheard of in the last forty years.

The downfall of commercial papers is the investment itself. They are typically not offered in lower denominations, and are oftentimes investments of $100,000 or more. This eliminates commercial papers as a viable investment opportunity for those with less money to put in money market securities. They are also unsecured, so this should be considered when determining whether commercial papers are an effective short-term investment for your portfolio.

Bankers Acceptance

Bankers Acceptance If you are wanting a short-term credit investment that does not go through a financial institution but is still guaranteed by a bank, bankers’ acceptance (BA) may be the investment for you. These are typically traded through a secondary market and can be done so at a discounted amount from the original face value. What is nice about BAs is that they have a negotiable time frame for investing and does not have to be kept through to a maturity date–it can actually be sold off or traded in these secondary markets. These are most often used in international trade.

Eurodollars

Eurodollars are actually not specifically related to Europe money market investments as one would automatically assume. They are actually oversea bank deposits figured off of the U.S. dollar. While they may have originated in London, the transactions can actually be anywhere outside of this country.

EurodollarsEurodollars are often transacted in extremely high denominations, so they are only within reach for serious high-dollar investors or those who are investing in money market funds through another institution. They are very similar in style to a certificate of deposit, being short-term securities (often six months or less in maturity). They are less liquid than domestic CDs, so their yields are typically higher. This is not a common way of investing money due to the high denominations, but they are growing in popularity due to their higher yields than domestic money market securities.

Repos – Repurchase Agreements

Repurchase AgreementsFor extremely short-term investments, many may consider repos. Repos, or repurchase agreements, are securities that are considered overnight borrowing in many circumstances. They can be longer, but are typically anywhere from overnight to thirty days of investment. They are low risk due to being backed by the government, and come in two forms: reverse repo and term repo.

As you have learned, there are various ways to invest in money market securities Whether you’re considering bonds, Eurodollars, repos or certificates of deposit, you will be able to find an investment that works best for you. Knowing the risks associated with each option–as well as the rewards–will allow you the opportunity to make an informed decision on the yield, maturity, and amount invested in each money market security. Considering diversifying your portfolio is smart for long-term investing for retirement, savings, or other financial stability, and money market securities are the perfect way to incorporate short-term investing into your financial plans.