The Effect of Interest Rates on Money Market Funds

Investors seeking safety and liquidity can park their cash in money market funds, which invest in government and corporate short-term bonds, as well as repurchase agreements and certificates of deposit. These are safe investments that pay a relatively low rate of interest. Money markets guarantee a stable value of $1 a share and, for a brief period, had an insurance program to reimburse shareholders in case their fund "breaks the buck." Although the cash you invest in a money market is safe, the interest paid on the money fluctuates with market rates.

Short-term bonds and certificates of deposit pay a lower rate of interest than long-term fixed-income securities. For this reason, the income earned on money-market funds is relatively low, although the principle amount you invest in a money market should never lose value. If short-term interest rates rise, then the dividends paid out by a money-market fund should increase as well.

Rising interest rates generally mean a fall in the market value of fixed-income investments. This also affects money market funds, but because the funds must, by law, own only short-term investments, the effect is limited. While the dividends returned by the fund may increase, the net asset value of the fund should always stay at $1.

During the financial crisis of 2008, investors fearing a run on money market funds began demanding redemption of their shares. Before a nationwide run on the funds could develop, the U.S. government established an insurance program that guaranteed investors against any losses. The funds paid a fee to join the program; if a member fund dropped below $1 of net asset value, the program stepped in to restore the any losses to investors. The program was only in effect for assets invested before September 19, 2008. Although it expired in 2009, the guarantee program set a precedent for future interventions by the government.

When interest rates fall, money markets deliver smaller yields. This becomes a problem when bank deposit accounts return the same or a similar rate -- as most investors consider bank deposits a safer place to park money, thanks to a guarantee provided by the Federal Deposit Insurance Corporation. By late 2012, interest rates on many large money market funds had fallen to .05 percent or even less; if the fund is taxable, for all practical purposes such a rate represents a zero return.