Cashing in With the Vanguard Tax Exempt Money Market Fund

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Over the weekend, I was poking around the Vanguard website when I ran across this little tidbit of information… The Vanguard Tax Exempt Money Market Fund (VMSXX) is currently yielding 4.53% (as of 10/13/2008). On top of that, it’s exempt from federal income tax. Thus, assuming that you’re in the 30% tax bracket, that’s the equivalent of a 6.47% yield (i.e., 4.53%/0.70 = 6.47%).

Why such a high rate?

According to Vanguard:

The yields of Vanguard’s municipal money market funds have risen dramatically in recent days. In a reversal of the usual relationship between yields of municipal and taxable money market funds, the yields of Vanguard Tax-Exempt Money Market Fund and similar state-specific funds have risen far above those of taxable funds, including Vanguard Prime, Federal, and Treasury Money Market Funds.

The unusual situation is being caused by current conditions in the short-term debt market. Many firms that help create and market short-term municipal securities for state and local governments are finding they need to boost yields to create greater demand for these securities. As a result, securities with extremely short maturities—including those that mature in one day or one week—are being offered at exceptionally attractive yields.

As part of their normal operations, Vanguard’s tax-exempt money market funds purchase these kinds of short-term securities every day, causing the funds’ yields to move in step with the yields being offered in the marketplace.

Source: Vanguard.com

The downside

While this is an incredibly attractive rate, it’s important to keep in mind that money market mutual funds aren’t typically insured against losses. Yes, Vanguard is participating in the U.S. Treasury money market fund insurance program, but that applies only to funds that were already in place as of September 19th, 2008. While fund companies strive to maintain a price of $1/share, there are no guarantees.

12 Responses to “Cashing in With the Vanguard Tax Exempt Money Market Fund”

  1. Anonymous

    Fortunately they’re investing in tax-exempt bonds, which are munis, which are linked to the financial solvencies of state governments. The money market funds that broke the buck had invested in corporate bonds, specifically Lehman, so you’d think these are “safer” than typical money market funds.

    Comment by jim — Oct 13th 2008 @ 2:59 pm
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    Jim, that’s not correct. A muni bond (tax exempt) can be backed by the “full faith and credit” of the municipality or state but they are not all that way. A General Obligation (GO) bond has that backing but other types (like Revenue) do not. Their payback may be based on many things – utilities or simply a payment stream on a city parking lot, tolls, rents on buildings, or whatnot. Any large fund or MM will include a mixture of all types of munis – not just GO.

    IMHO, part of the reason muni yields have increased is because of the fear of failure of some of these bonds and partly because people have been fleeing everything in favor of the safest investment – US Treasuries. What the future holds is anybody’s guess.

  2. Anonymous

    Read between the lines. Higher rates are great for us investors, but they also increase the cost to the taxpayer. If a municipal is having trouble selling it’s debt, it has to raise its rate. And it usually has trouble because they have too much debt, such as California. Next stop, higher Treasury rates to pay for the bailout, Fannie and Freddie.

  3. Anonymous

    Yeah. I got it. The assumption is that is it was taxable, it had better be earning the 6.47%. Both of our math was correct, just different views. Thanks for seeing through my head cold…

  4. Randy: Look at it this way… If you had to pay 30% federal taxes on it, you’d have to earn 6.47% in order to keep 4.53% after federal taxes (i.e., 6.47% x 0.70 = 4.53%). So… The lack of federal taxes makes it the equivalent of earning 6.47% in a fund on which you have to pay federal income tax. Make sense?

  5. Anonymous

    Isn’t it still a 4.53% return, because assuming a 30% tax bracket your real return, if taxed would be 3.17%?

    I do have a crazy head cold today, so it is feasible I have this backwards and that you are, in fact, correct.

  6. Anonymous

    State and municpal governments are having a difficult time refinancing short term debt. As a result, Muni MMF’s are getting great rates BUT: if something sounds to good to be true, it probably is. Many states and municipalities are facing rising expenses and lower tax revenues (because of lower incomes). The higher yield in muni’s reflects the market’s perception of their risk – higher.

  7. Anonymous

    Nickel: I’m aware of that. “those mff” refers to those pre sep19th. the treasury would again back $1 for $1 if there was any further chance of mff declining. the guarantee of the pre-sep19th assures this that is why there is no chance of mff dropping again. i’ll eat my shoe if i’m wrong.

  8. Tim: The new Treasury insurance plan only covers money that was invested in a MMF as of Sept 19th. I wrote about this earlier in the day. Thus, while I agree that’s it’s unlikely you would ever lose money with this fund, it’s not guaranteed unless you were previously invested.

  9. Anonymous

    yes, but…since the treasury is backing those mff, there is less than .000001% of your money going for less than $1 for $1 now unless the fund provider itself busts.

  10. Anonymous

    Fortunately they’re investing in tax-exempt bonds, which are munis, which are linked to the financial solvencies of state governments. The money market funds that broke the buck had invested in corporate bonds, specifically Lehman, so you’d think these are “safer” than typical money market funds.

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