Money market funds get volatile

The San Francisco Chronicle reports:

One of the quietest corners of the financial world has suddenly become one of the most unsettled.

I'm talking about tax-free money market funds, which invest in ultra-short-term, tax-free securities issued by states, cities and other municipalities.

These funds, which pay tax-exempt income, typically yield a bit less than taxable money funds. But for higher-income people, they usually yield more than taxable money funds after you subtract the tax owed on the latter. The higher your tax bracket, the bigger the benefit of tax-free funds.

While yields on all money market funds have fallen since the Federal Reserve's rate cuts, the yields on tax-free funds have virtually collapsed.

On Dec. 3, the average tax-free money market fund was yielding 3.06 percent - about 75 percent of the average taxable money fund yield of 4.1 percent.

A week ago, tax-free money funds were yielding a scant 1.41 percent - only 46 percent of the average taxable money fund yield of 3.05 percent, according to iMoneyNet. If that unusual relationship were to persist, tax-free money market funds wouldn't even make sense for the highest-income taxpayers.

Tax-free yields have improved since last week but are still abnormally low relative to taxables.

A handful of tax-free money market funds have resorted to buying taxable securities, presumably to increase their yields. That unusual move could produce a surprise tax hit for shareholders who thought they'd purchased a tax-exempt vehicle.

Most tax-free money market funds have the right to buy a limited amount of taxable securities, and other funds could be doing it, too, without disclosing it.

The plunge in tax-free money-fund yields stands in stark contrast to what's happening at the other end of the municipal-bond spectrum. Yields on medium- and long-term tax-free mutual funds have been rising relative to their taxable counterparts.

What's to blame for this turn of events?

The mortgage mess, of course.

More than half of all municipal securities are insured by a handful of companies, including Ambac Assurance Corp., MBIA Insurance Corp. and Financial Guaranty Insurance Co.

Until recently, all of these companies had solid, AAA credit ratings.

A city that had a slightly lower AA credit rating, for example, could pay one of these companies to guarantee that its bonds would be repaid. This insurance gave the city's bonds an AAA rating and let it sell them at a slightly lower interest rate than if it had sold them with its own AA rating.

In recent years, these companies also started insuring mortgage-backed securities. The crisis in that market has put most of the insurers' credit ratings at risk. Some have already been downgraded. If an insurer is downgraded, the bonds it insures will be downgraded as well.

Even though municipal bond defaults are extremely rare, investors - including mutual funds - have been dumping or trying to dump securities backed by the troubled insurers. The price of those securities is plunging, and their yields - which move in the opposite direction - are rising.

"Money market funds are supposed to be very conservative," says Cameron Ullyatt, who manges tax-free money funds for Oppenheimer Funds. "We are selling that paper right and left."

What a story.