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Tiny yields challenge money funds, investors

BOSTON — Three months after the government stepped in to prop up reeling money-market funds, the $3.8 trillion industry is largely healthy again, with money flowing back to the safe-harbor investments at a steady clip.

But there's one problem: Yields for the safest category of money funds, those that invest in Treasury bills, have sunk to near zero. That means fund companies' returns are barely enough to offset expenses to run the funds unless yields creep back up again soon — a prospect considered unlikely, given that the Federal Reserve will need more time for its rate-cutting campaign to take hold.

Dropping yields at Treasury-only money-market funds aren't expected to trigger investor losses, and money-market funds — including higher-yielding prime funds that invest in corporate debt — remain safe places to park cash after the hit stocks have taken this year.

“If Treasury funds yielding zero is your biggest problem in these markets, congratulations,” said Peter Crane of Crane Data, publisher of the newsletter Money Fund Intelligence.

But declining yields are eating away at the already slim returns clients expect from money funds. The average yield for funds investing exclusively in T-bills now stands at 0.20 percent, according to iMoneyNet, another money fund research firm. That means an investor plowing $1,000 into a Treasury-only fund would see a return of $20 after a year.

The current 0.20 percent average is below the 0.32 low hit in early 2004, the last time the industry saw comparably low yields, according to iMoneyNet.

With the realistic possibility that fund companies may temporarily start to suffer losses at their lowest-yielding funds, some providers are responding by closing Treasury-only funds to new investors, or limiting new investments by existing clients. For example, Vanguard recently imposed new restrictions at a couple of its Treasury money-market funds.

If low yields persist, more companies may decide to merge funds into other funds, or shut down some and make full returns of investors' cash.

Others are reducing or waiving management fees to ensure clients make modest gains. But eventually, providers might pass more costs onto clients in the form of new fees.

“Realistically, the companies have to do something to cover their expenses,” said Connie Bugbee of iMoneyNet, publisher of the newsletter Money Fund Report. “And if you're not passing on many of those expenses to shareholders, then you're eating some of those expenses yourself. And that can't go on forever.”

Still, times are better for money funds than three months ago, when a large fund called the Reserve Primary Fund exposed investors to losses because of a soured investment in Lehman Brothers. That episode of a fund “breaking the buck” — in which the value of the fund's assets fell below $1 for each investor dollar put in — triggered a rush out of prime funds investing in corporate debt until the federal government offered guarantees to back money funds.

Now, with guarantees in place, total money-market mutual fund assets are up nearly 12 percent to a record $3.8 trillion, from a recent low of $3.4 trillion in late September.

Prime funds in particular are seeing new money coming in, thanks to government help to unfreeze the market for commercial paper — a type of short-term corporate debt that prime funds invest in.

With some prime funds carrying yields above 2 percent, those funds have enough of a yield cushion to offset expenses.

But prospects are grim for the 20 percent of the money fund industry's total assets in the lowest-yielding and safest category: funds that invest exclusively in virtually risk-free T-bills.

Crane, of Crane Data, said even if some of those funds aren't able to maintain yields big enough to offset expenses, they'll have enough financial cushion to ride things out until yields rebound.

“This is a gradual problem that fund companies will have plenty of time to deal with,” Crane said.

Still, Crane and other experts caution investors should watch out to protect what little returns they can expect from low-yielding money funds:

Watch the fees: Monitor any disclosures about new fees to offset the hit fund companies may be taking from near-zero yields and their earlier moves to temporarily waive management fees.

“You might see a new account fee, or higher wire transfer fees,” said Crane, who compared the situation to banks that begin offering free checking accounts but raise fees for other services such as covering bounced checks.

Compare expenses: Higher expenses charged to run the fund loom larger when the fund's yield dwindles.

“The money-market funds that you'll see getting squeezed in this environment will be the higher-cost providers, because that expense ratio is deducted directly from your yield,” said Christine Benz, Morningstar Inc.'s director of personal finance. “And if expenses are higher than the yield a fund is able to pay, it just doesn't make sense to continue operating it.”

Carefully review the fund's Web site for expense ratios.

“I've noticed the higher those expenses are, the harder they are to find,” Benz said. “You want a company that is very forthright about disclosing what it's charging you.”

As a rule of thumb, Benz advises looking for money funds with expense ratios of 0.5 percent or less — and “as rock bottom as it can be” for funds investing in T-bills.

Consider more risk: If you want a little more return than you'll get from a low-yielding Treasury fund, consider moving to other categories of money funds.

“This is an excellent opportunity for people who overreacted in the first place and went into Treasuries to now take a baby step out on the risk curve, and move into government funds or prime funds,” Crane said. “In the grand scheme of things, you're still talking about minimal risk compared with the savage beating that's taken place in other markets recently.”

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