Download Short-Term Savings Vehicles: Money Markets, MARS and VRDOs

August 2004
Short-Term Savings Vehicles: Money Markets, MARS and VRDOs
Overview: This article discusses money market funds and the role a money market fund can play in an investor’s portfolio. In addition, we introduce two alternatives to money market funds: MARS (municipal auction rate
securities) and VRDOs (variable rate demand obligations). Although MARS and VRDOs are actually long-term
bonds, these securities have many of the same characteristics as money market funds, including carrying high
credit quality and offering greater liquidity than other asset classes. However, expected yields for MARS and
VRDOs typically resemble short-term bond yields, which can be higher than money market fund yields. Thus, an
investor could substitute MARS or VRDOs for a money market fund in a portfolio, accepting the same level of
risk associated with money market funds while potentially receiving higher returns. The article also describes
how the bonds are structured and discusses when it might be appropriate for investors to include either MARS
or VRDOs in their portfolios.
What is a Money Market Fund?
A money market fund is an open-end mutual fund that invests only in short-term debt obligations.
Money market funds involve almost no interest rate risk, as they must adhere to the following SEC
regulations:

They must build highly diversified portfolios composed of the securities of creditworthy corporations, banks and other financial institutions, as well as federal, state and local governments.

The average maturity of the fund cannot exceed 90 days, although the term of any one instrument held within the fund can be longer. The maximum maturity is approximately 13 months.
The generally high credit quality of the investments included in most money market funds and payment of monthly interest to investors allows money market funds to maintain a net asset value
(NAV) of $1 per share.
The Role of a Money Market Fund in a Portfolio
Why would an investor choose to place assets in a money market fund? Preservation of principal
is the main objective. Therefore, investors should regard money market funds as savings vehicles,
not investments. Investors typically use money market funds to hold assets for unexpected expenses,
or as a “parking place” for assets that will be invested or consumed in the near future. Most financial
planners recommend that investors hold an amount equal to 3–6 months of living expenses in a
money market fund (or other very short-term fund with a similar high credit quality) for the prover-
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bial “rainy day.” Given this role that money market funds typically play in an investor’s portfolio,
investors should seek funds that invest only in the highest investment grade securities.
Considering the limitations placed on typical money market funds by the SEC regarding the length
of an investment’s maturity (which restricts a fund’s ability to take interest rate risk), investors might
choose a money market fund on the basis of which fund has the lowest cost. The average money
market fund has expenses of about 0.6 percent but some funds have expenses much lower than this
ratio.1 Unfortunately, they can be much higher — often in excess of 1.0 percent. Investors should be
aware of these fees.
Convenience can also come into play when choosing a money market fund. For example, an investor might be willing to pay relatively higher expenses for the convenience of check-writing privileges, or for having most of his or her investments with one custodian.
A word of caution when looking at a fund’s operating expense ratio. Sometimes, funds will waive
part of their expenses. To determine if a fund is gaining its cost advantage by maintaining low expenses over time or simply waiving fees, investors should review the fund’s prospectus. When selecting a money market fund, investors also must choose between taxable and tax-exempt money
market funds. Taxable and tax-exempt funds are different for at least three reasons: 1) the tax status
of the fund, 2) the class of securities that a fund might invest in, and 3) the expected pre-tax yield,
which is usually higher for taxable funds.
Taxable Money Market Funds
There are three types of taxable money market funds:

Treasury only — Treasury funds only invest in direct U.S. Treasury obligations, which carry no
credit risk. Interest earned is exempt from state and local taxes.

U.S. government — U.S. government funds hold obligations of the Treasury and U.S. government sponsored enterprises. In this category, GNMA is the only government agency whose debt
carries the full faith and credit of the U.S. government, carrying no credit risk. For Federal
Home Loan Bank System (FHLB) and Farm Credit System (FFCB), interest earned on their securities is exempt from state and local taxes. Fannie Mae and Freddie Mac bond interest is subject to state and local taxes.

General funds — These funds try to achieve higher returns by investing in the short-term debt
of large, high-quality corporations and banks in addition to U.S government debt. Depending on
the securities the funds invest in, interest earned may not be exempt from state and local taxes.
Tax-Exempt (Municipal) Money Market Funds
Tax-exempt or municipal money market funds invest in the short-term securities of state and local government agencies and provide tax-free dividend income (subject to the limitations imposed
by the alternative minimum tax rules, or AMT). There are two types of tax-exempt funds: 1) national
tax-exempt funds and 2) single state tax-exempt funds.
National tax-exempt money market funds invest in municipal obligations issued by state and local
governments and such funds provide income free of federal income taxes. However, most states
only provide a tax exemption to residents for interest earned on debt obligations from that state.
This creates the need for single state funds that only invest in the municipal obligations of a single
state. Depending on an investor’s state tax rate, he or she might choose to invest in a national or
single state fund.
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While a tax-exempt money market fund has appeal, sometimes the mathematics work out so that a
taxable fund will actually provide an investor with higher expected after-tax returns. The yield curve
for municipal (tax-exempt) issues is generally steeper (short-term rates providing relatively lower
yields) than it is for taxable issues.
The Appeal of Money Market Funds: Safeguarding Principal
Although money market funds do not provide a guarantee against loss, they have an almost unblemished track record — thanks to the tight restrictions imposed by the SEC. For competitive reasons,
most fund sponsors have maintained policies that prevent funds from “breaking the buck” (letting
the NAV fall below $1), lest they shatter investor confidence.
There have been several instances where fund sponsors subsidized a fund’s value because of credit
losses. Funds with higher expenses that seek to keep their net yield competitive by investing in riskier securities can sometimes incur losses. In addition, the very low interest rate environment of 2003–
2004 forced some companies to temporarily waive fund fees, to prevent those funds from providing
negative returns.
While money market funds are the most common instrument used for saving because of their convenience and safety, two municipal bond security types — Municipal Auction Rate Securities
(MARS) and Variable Rate Demand Obligations (VRDOs) — can serve a comparable purpose. In
some instances that we will describe in more detail below, MARS and VRDOs (which are also categorized as savings vehicles) can add value to a portfolio above the value provided by money market
funds.
Alternatives to Money Market Funds: MARS and VRDOs
Although MARS and VRDOs are actually long-term bonds, these securities have many of the same
characteristics as money market funds, including offering greater liquidity than other asset classes
(such as equities or bonds) and carrying high credit quality. For example, the credit ratings of most
MARS range from AAA to A.2 Because of the unique structure of the bonds, both MARS and
VRDOs are commonly assigned both a long-term and short-term rating. However, if an investor
purchases MARS or VRDOs as a substitute for a money market fund — and thus does not plan to
hold the bonds to maturity — he or she might only need to concentrate on the bond’s short-term
rating.3
Investors seeking to gain higher expected returns without jeopardizing principal or increasing credit
risk might find that either MARS or VRDOs can be acceptable alternatives to money market funds.
Because of minimum lot sizes, investors usually need a minimum of $100,000 to purchase such
bonds but some bonds can be purchased in smaller denominations. However, due to custodian
transaction fees charged for each trade, small and odd lot purchases are discouraged.
In terms of liquidity, some bonds offer daily, weekly, or monthly reset schedules. This means that
even though a bond may mature in 2035, it can have a daily interest pay date (with a daily coupon
rate) and an optional redemption provision that allows investors to redeem their principal at par4 on
any of those interest pay dates. Further, if money market funds were to offer higher interest rates
than MARS or VRDOs, an investor could sell the bonds at par, which is the price paid for the
bonds, and then move the assets to a money market fund (if such a move were appropriate) because
MARS and VRDOs have relatively high liquidity.
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Expected yields for MARS and VRDOs typically resemble short-term bond yields. Although one
would expect tax-exempt bond yields to be lower than taxable money market yields (since taxexempt yields have historically been lower than taxable yields), at the time of this paper, MARS and
VRDOs yields were higher than money market fund yields. For example, a Schwab money market
fund offered a seven–day current yield of 0.78 percent (as of June 30, 2004).5 A VRDO with a maturity date of 2040 had a rate of 1.03 percent (as of July 1, 2004).6
The VRDO in Figure I below has a maturity date of 2040 and a daily coupon rate, which means the
coupon rate resets (and could be different) each business day. Since the rate resets in line with the
federal funds rate, investors who buy MARS or VRDOs are typically taking only a minimal amount
of market risk. In addition, the bond in Figure I can be sold on any business day with par liquidity.
Figure I: Bloomberg, July 2004
MARS and VRDOs: Limited Availability Can Affect Liquidity
One major drawback associated with MARS and VRDOs could be their limited availability. The
combination of high credit ratings, high liquidity and higher expected returns (based on comparable
investment vehicles, such as money market funds) adds up to an attractive, low-risk investment.
However, it also means that MARS and VRDOs are highly sought after and sometimes hard to locate. Therefore, investors should be prepared to allow more than one day’s time to purchase such
bonds.
To summarize, while many of these bonds provide daily liquidity (VRDOs) and weekly or monthly
liquidity (MARS), purchasing smaller lot sizes and initiating frequent transactions should be avoided
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due to custodian transaction fees. Investors should regard the liquidity of MARS and VRDOs as a
valuable feature, which an investor could use if emergency assets were needed unexpectedly or interest rates changed, increasing the yields of money market funds. We would suggest that investors
view the bonds as they would money market funds —a place to store disposable assets while earning
a small amount of interest normally associated with savings vehicles.
Money market funds, MARS and VRDOs are all considered savings vehicles. Investors with greater liquidity needs have a stronger incentive to use MARS and VRDOs. However, MARS and
VRDOs are not appropriate for every portfolio. If an investor has no liquidity needs, he or she may
wish to consider other alternatives, such as moving assets out of savings vehicles into investment
vehicles. For example, some investors may try to use MARS or VRDOs as investment vehicles. Investors seeking to incorporate short-term bonds into their overall portfolio might find it is more effective to invest in bond funds or build a bond ladder with a 2–8 year range. We would caution investors against using savings vehicles as investments and against using investment vehicles as a
parking place for emergency assets.
What to Consider before Choosing MARS or VRDOs over Money Market Funds
Investors might want to consider these factors associated with MARS and VRDOs:

Because of the bonds’ limited availability, it is more difficult to locate suitable bonds. Because of
this (and trading costs associated with MARS and VRDOs), investors should plan to hold such
bonds for at least one month after their purchase.

Because of minimum lot sizes, investors usually need a minimum of $100,000 to purchase such
bonds.

Even if an investor is in a low tax bracket, he or she can still benefit from choosing tax-exempt
MARS and VRDOs over money market funds.
Summary
It is typical for investors to consider holding some assets in a savings vehicle for unexpected expenses. The convenience and safety of money market funds — along with low (or no) minimum initial
investment requirement — have made them popular vehicles. Given the role of a money market
fund in a portfolio, investors might seek funds with a track record of very low expenses and a history of investing only in the strongest credits. In addition, an investor will need to choose between
taxable and tax-exempt money market funds. However, some investors — including those investors
in a low tax bracket — might be able to gain higher expected returns by using MARS or VRDOs
instead of money market funds.
MARS and VRDOs are also considered savings vehicles, since they provide a higher level of liquidity than other bonds — with daily, weekly or monthly coupon rates and redemption schedules —
that allow an investor to redeem such bonds at par. In addition, these low-risk investment vehicles
can potentially offer higher yields than other savings vehicles. At the time of this paper, tax-exempt
MARS and VRDOs were offering significantly higher yields than some money market funds. Although some investors might not consider MARS and VRDOs traditional savings vehicles, these
bonds remain a prudent choice for investors seeking to do more with their liquid assets.
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Taxable money market funds for individuals have … charged a “0.6% average asset-weighted expense ratio.” Karen
Damato, Some Money Funds May Miss Benefit of Rising Rates. The Wall Street Journal, June 25, 2004.
Moody’s Investors Service uses a ratings system that ranges from A–C. Each rating is divided into additional grades,
such as Aaa, Aa and A, or sub-grades such as Aa1, Aa2 and Aa3. For example, the highest bond rating is Aaa and
such bonds have the “smallest degree of investment risk.” Bonds rated C have “extremely poor prospects of ever attaining any real investment standing.” Bloomberg, July 2, 2004
The short-term grades assigned to a bond, which relate to state and municipal short-term loan ratings, include VMIG1,
VMIG2, and VMIG3. Bloomberg, July 2, 2004.
Bond issues such as MARS and VRDOs can offer par in/par out liquidity on a daily basis, which means that those
bonds can be redeemed daily and there are usually no concerns regarding loss of principal.
Advertised yield for Schwab Value Advantage Money Fund – Investor Shares. https://ssl.schwabinstitutional.com,
July 2, 2004.
Coupon rate for Missouri State Health & Educational municipal bond (VAR–Washington University–SER C). Bloomberg, July 2, 2004.
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The
content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice.
To be distributed only by a registered investment advisor. Copyright © BAM Advisor Services, 2004.
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