Question: I want to put some money in a local money market fund, but I am scared as these funds are not insured and do not guarantee even the principal. What should a prospective investor look for in selecting a fund, other than the seven-day average yield? Have any of the money market funds gone under?
Answer: To my knowledge no money market fund has collapsed, gone broke or had any unresolved liquidity problems. They generally invest in high-quality corporate or goverment "paper" (market jargon for short-term loans).
But if the lack of federal insurance or guarantee bothers you, there are some money market funds that invest only in securities of the federal government or of federal agencies.
To get this extra bit of safety you will have to accept a slightly lower yield. Funds that restrict their portfolio to federal securities usually pay from a half to a full percentage point less than the general money market funds.
You should look at 30-day yield as well as the seven-day return, to get a feeling for the direction of the yield, and how the particular fund you're interested in compares with the industry trend.
In addition, look at maturity length. That number--the average maturity, in days, of the fund's portfolio--will tell you if and by how long the yield is liable to lag changes in market interest rates.
If rates fall, a long maturity will permit the fund to continue to pay a high return for a while, until the portfolio is rolled over. But if you expect interest rates to rise, look for short maturity; the fund then isn't locked into lower rates for a relatively long time.
Dollar minimums for initial and subsequent deposits, ease of withdrawal (most funds provide free check-writing), fees or charges and the experience and reputation of the fund sponsor are other factors to look at.
Q: If I buy a single-premium deferred annuity at 14 1/4 percent guaranteed for one year with a bailout rate of 13 1/2 percent, what are the risks of the income being reduced by lower interest rates in the future?
A: If I had a reliable crystal ball, I could give you a pretty good estimate of the risks involved.
Future movement of interest rates depends on a number of unpredictable variables, including the course of inflation, the size of the federal deficit (which of course determines the amount of federal borrowing) and how the economy moves (which affects corporate and personal demand for credit).
About the only thing you can be pretty sure of is that if next year's return on the annuity drops below the bailout rate, the return on alternative investments will have dropped also.
In fact, insurance companies offering bailout levels on their annuities count on a corresponding drop in alternative yields to keep most investors, if not locked in, at least wedded to their annuities even at yields below the bailout point.
(For readers who aren't familiar with the term, "bailout rate" refers to the investor's right to withdraw his funds without penalty if the rate of return on the annuity drops below a specified point--in this case, 13 1/2 percent.)
On May 3 I wrote that the IRS would permit a Schedule A deduction for interest expense on a margin account even though an investor owned municipal (tax-free) bonds, provided that the bond purchases were segregated from the margin account.
But Stephen D. Tanner, a CPA from Morgantown, W. Va., took me to task for that answer, citing--among other references--Revenue Procedure 72-18.
Turns out he's right. What seemed like a logical answer to me, based on the research I did, also sounded reasonable to my contact at the IRS when I first posed the question.
Armed with Tanner's references, the research was taken a little further. Result: The IRS says an interest deduction may not be taken for the same time period in which a taxpayer owns tax-free bonds, except for mortgage interest, loans for cars and similar personal items and business loans.
Which means that you may not claim a deduction for any interest expense related to investments to the extent of any tax-exempt investments that you own at the same time.