Money Market Funds come under Scrutiny

August 22, 2007

SAN DIEGO (ETFguide.com) - This year’s mortgage debt credit crunch has had such an impact, it’s creating tremors in the relatively tranquil world of money market funds.

The ‘safety net’ of mutual funds that invest in these short term debt instruments is now being questioned. How much exposure do these funds have to high risk loans?

By law, money market funds are required to invest at least 95 percent of their assets in high quality short term debt. This includes, among other things, commercial paper that’s rated at least A-1 by Standard & Poor’s or P-1 by Moody’s. But there’s a caveat: A fund holding quality rated debt that is later downgraded can keep its original investment. Instead of selling the downgraded debt, many funds choose to continue owning it, betting that it won’t default.

Another issue is money market funds owning unrated debt.

To capture higher yields, some money market funds may end up buying unrated commercial and municipal debt. Since unrated doesn’t necessarily mean poor quality, it’s up to fund managers to judge their ultimate worth. Is it possible some fund managers have been investing in questionable quality debt in an attempt to chase higher yields? Such a scenario could cause pricing discrepancies and even unexpected losses. Most money market funds aim to keep their shares pegged to $1 dollar per share value.

Investors seeking safe haven could turn to exchange-traded funds (ETFs) that invest exclusively in U.S. Treasuries and government backed bonds.

Barclays Global Investors offers the iShares Lehman Short Treasury Bond Fund (Ticker: SHV) which has government bond durations of less than 1 year. The company also offers a series of five U.S Treasury Bond ETFs with maturity periods ranging from 1 to 25 years. The iShares Lehman 3-7 Year Treasury Bond Fund (Ticker: IEI) is one such fund. These particular ETFs carry annual expense ratios of 0.15 percent.

Also, the Vanguard Group recently launched a series of bond ETFs that track similar Lehman Brothers bond indices, but with a mix of investment grade corporates and U.S Treasuries.

The Vanguard Short-Term Bond ETF (Ticker: BSV), Vanguard Intermediate-Term Bond ETF (Ticker: BIV) and the Vanguard Long-Term Bond ETF (Ticker: BLV) compete

directly with the iShares and carry annual expense ratios of 0.11 percent.