As Investors Yank $1.87 Billion, Funds Fall Below $400B

Cash continues to run off the sidelines as investors lose patience with the minuscule returns offered by short-term safe havens.

Investors withdrew $1.87 billion from their tax-free money market funds during the week ended Dec. 29, according to ­iMoneyNet. Investors have ferried more than $92 billion from tax-free money funds in 2009.

The tax-free money fund industry now manages less than $400 billion, which according to Lipper FMI is the lowest total since June 2007.

The industry’s assets have shrunk 23% since peaking at well more than $500 billion in August 2008.

It is no secret why investors have lost interest in money market funds. They offer almost no yield.

The average tax-free money market fund currently yields 0.05%, according to iMoneyNet. The average yield has been even lower for much of the fourth quarter.

Money market funds invest in super-safe and super-short-term paper to offer investors the equivalent of cash. The entire money market fund industry manages $3.26 trillion.

Tax-free money funds invest mainly in short-term notes issued by municipal bodies, such as variable-rate demand notes that enable the holder to sell the paper back to the issuer on demand.

The main reason yields on this paper are so low is the Federal Reserve’s campaign to keep short-term interest rates pinned to the floor.

A second factor is a shortage of municipal paper eligible to be purchased by money market funds.

Municipal VRDNs typically require a credit guarantee from a bank. As the banks spent much of 2009 nursing their balance sheets, credit guarantees became more expensive and difficult to obtain.

According to preliminary numbers from Thomson Reuters, in 2009 municipalities sold just $32.16 billion in variable-rate notes granting the holder the right to sell the paper back to the issuer. That represents a decline of 72.3% from 2008.

The decline in issuance has left the 500-plus tax-free money fund industry scrapping for what is available, dragging down yields.

A third factor has exacerbated the scarcity of tax-free money market-eligible paper: competition in the taxable money fund industry is even worse. Taxable money funds have begun snapping up tax-exempt municipal paper because the yields on taxable paper are even lower, said Chris Carter, a tax-exempt money fund manager at RidgeWorth Investments.

Carter does not see tax-free money funds’ prospects improving anytime soon. The Fed remains committed to keeping its interest rate target at essentially zero, and Carter does not foresee a rate hike until 2011.

In fact, considering that many funds have waived a portion of their fees, Carter is surprised more money funds have not closed shop or converted to short-term bond funds.

According to the Investment Company Institute, 511 funds are classified as tax-free money funds, down from 565 at the beginning of the year.

Much of the cash leaving tax-free money funds is likely going to municipal bond mutual funds, Carter said.

Muni mutual funds have recorded $78 billion in new money from investors this year, according to Lipper.

Many investors either can no longer tolerate money funds’ low yields or have gained enough comfort to move out into longer-term debt, Carter said.

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