What are money market funds?

Kavya Balaji   /   April 16, 2021

Money market funds are mutual funds that help investors manage short-term cash needs. These are open-ended funds and belong to the debt fund category. Money market funds invest in money market securities. These funds usually deal only in shorter term investments, cash or cash equivalents. Money market securities are those investments that have an average maturity of less than one year. 

Money market funds invest in high quality financial securities such as certificate of deposit, treasury bills, repurchase agreements, and commercial papers. These funds have the goal of earning income for the unitholders. Since the investments are for the short term, there will be lesser fluctuations of the Net Asset Value (NAV) of the fund.

What are the kinds of money market investments?

Here are some of the financial securities that are part of the money market funds’ investments.

Certificate of Deposit (CD) – Scheduled commercial banks offer time deposits that are fixed deposits that have a tenure and can be redeemed only at maturity. These might be deposits held by companies and institutions.

Treasury Bills (T-bills) – These are financial securities that are issued by the Government of India. These bills are used to raise money for a tenure of up to 365 days. T-bills are one of the safest investments as they come with sovereign guarantee. The interest rate offered for T-bills is known as the risk-free rate of return. The interest rate is low on T-bills when compared to all other investments. 

Commercial Paper (CPs) – These investments are issued by companies and financial institutions that have a high credit rating. Commercial papers are also known as promissory notes. They are unsecured investments. However, these investments are issued at a discount and are redeemed at face value.

Repurchase Agreements (Repos) – This is an investment that is an agreement under which the Reserve Bank of India (RBI) lends money to commercial banks. 

Who should invest in these funds?

Money market funds invest in diverse short term financial securities and offer income to investors who want an alternative to savings account and fixed deposits. Investors who have a short investment horizon of up to one year can consider investing in these funds.

Any investor who has a low-risk appetite can use money market funds to park their surplus cash that is in their savings bank account. Money market funds have the potential to offer higher returns than a regular savings bank account. Even though many corporates invest in these funds, retail investors can invest their surplus money in these funds.

What to consider when you invest in money market funds?

The first consideration should be the risks involved in money market funds. Money market funds come with interest rate risks, reinvestment risks and low credit risks. Interest rate risk is the risk that the prices of the investment will increase whenever interest rates decline and prices will decrease whenever interest rates rise. Reinvestment risk is the risk that there will be other investments offering higher interest rate when the investment is redeemed. Credit risk is the risk that the credit rating of the investment might be reduced. However, money market funds have very low credit risks as they invest in sovereign guarantee investments.

The second consideration is that the money market funds can offer higher returns than a savings bank account. 

The third consideration is the expense ratio or the fee charged by fund houses to manage the money market fund. The Securities Exchange Board of India has ruled that the expense ratio has to be capped at 1.05%. 

Investors should ensure that the money market fund’s maturity is in line with their own investment horizon. Money market funds are suitable for investment horizons that are three months to one year. For the medium-term, investors can consider other debt funds such as dynamic bond funds. 

What is the capital gains taxation for money market funds?

When you invest in money market mutual funds for three or more years, the gains once you sell will be long-term Capital Gains (LTCG). Short Term Capital Gains or STCG will be when you redeem the money market funds within three years. LTCG is taxed at the flat rate of 20% with indexation benefit. For STCG, the gains are added to your income and taxed according to your income bracket. 

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