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Fed Interest Rate Cut Stings Money Funds

Money market funds are once again taking it on the chin as they feel the sting of the 12th interest rate cut since January 2001.

The Federal Reserve Board cut the federal funds rate by another 50 basis points to 1.25% Nov. 6. That's the rate that commercial banks charge among themselves for overnight loans, and the current rate money funds receive when they invest in short-term money market securities.

While this is the first interest rate cut of 2002, money funds are still reeling from the 11 interest rate cuts of last year, down from an initial 6.5%.

In making its latest rate cut announcement, the Federal Reserve cited the need to further ease the monetary policy to help the U.S. "economy work its way through the current soft spot." Despite the economy's soft spot, money fund sponsors are finding themselves wedged between a rock and a hard place.

Many fund advisers, including Value Line, Nations Funds, INVESCO and Pioneer Funds, have been slashing fees to the bone to prevent their funds' returns from dropping to zero - or turning negative. That would be akin to dropping the fund's net asset value to less than $1 per share, also known as "breaking the buck."

In reaction to the rate cut, on Nov. 12, John Hancock Funds of Boston filed a notice with the SEC advising that it would be reducing its money fund's 12b-1 service and distribution fee by 25 basis points, effective immediately on its B and C share classes. These typically carry shareholder servicing fees or 12b-1 distribution fees.

Some funds didn't bother waiting for another rate cut and took early remedial steps. Munder Capital Management of Birmingham, Mich., adviser to the Munder Money Market Fund and the Munder Cash Investment Fund, will ask investors to approve a consolidation of the two money funds and a subsequent reduction in costs at a shareholder meeting Dec. 11.

"A lot more funds are going to have to cut expenses," said Peter Rizzo, director of investment services at Standard & Poor's in New York. While money funds have some wiggle room because they are still holding higher-yielding securities, when those securities mature, the real struggle will begin, he said. Another 50 to 100 funds are likely to break the buck, Rizzo added.

Falling interest rates aren't necessarily a bad thing for money funds. As rates change, money fund managers see parallel changes in the rates of return for the securities they purchase. Higher rates mean they garner a larger return on the short-term fixed-income securities they buy and pay higher returns to fund investors.

As rates fall, returns for both portfolio managers and investors do, too, although there for portfolio money fund managers, there is a lag time as higher-yielding portfolio securities are systematically converted to cash, and then reinvested in current lower yielding securities.


What has had money fund advisors scrambling, however, is the absolutely low level to which interest rates have fallen. Funds run the risk of having their already meager returns to investors utterly obliterated by management fees and other operating expenses. If fees and costs are allowed to exceed money fund returns, money funds' history of safety, while not FDIC insured, will become a myth.

As of Nov. 6, the average return across all taxable money funds was 1.2%, according to iMoneyNet in Westborough, Mass. [see MFMN 9/30/02]. Lipper of New York reported a 90 basis-point return.

For many money funds, the picture is much dimmer. About 70 money funds are currently paying investors a paltry 50 basis points, said Pete Crane, vice president and managing editor at iMoneyNet. Rates will sink even further as funds begin investing in even lower-yielding securities.

Despite being painful to fund advisers' coffers, waiving fees and eating expenses is the solution many money funds are resorting to in order not to break the buck. But another interest rate cut could be devastating to the industry, said industry executives. "Another rate cut of 25 or 50 basis points over the next few months would definitely put more pressure on money fund complexes," said Jim Hannan, managing director of fixed-income at Allied Investment Advisors of Baltimore.

That "would wreak havoc on the industry," said Crane of iMoneyNet. "Those forced to waive fees to prevent a negative yield would probably have serious discussions about merging or closing their funds, or outsourcing money funds to others," he added.


"I don't think rates will go to zero, but if they did, all funds would have to waive all of their fees," said S&P's Rizzo. "There would be disarray in the fund industry," he predicted.