Ultra-Short Bond Funds and Prime Money Funds

Which of these are you?

• You want a slightly higher return on reserve money and you would not flinch at a small paper loss. An ultra-short fund can fit in Tier 2 (Reserve) or Tier 3 (Strategic) if the dated goal is far enough away. Size the loss first, using the recovery formula below.
• You hold a brokerage sweep and wonder if a prime money fund is safer than a bond ETF. It is more tightly regulated, not insured. Read whether it is a retail or institutional class.
• The money is your one-month operating cash or your only emergency fund. Keep it in insured deposits or Treasury bills. Neither product type is built for that job.
• You saw a chart of funds that beat savings rates. The FFRHX, JAAA and SGOV article covers three specific funds. This chapter gives you the framework to judge any of them.

What a money market fund is bound to do

A money market fund is a mutual fund whose portfolio is limited by Rule 2a-7 under the Investment Company Act, and those limits are the reason it can aim for a steady share price. Each security generally must have a remaining maturity of 397 calendar days or less (the rule has exceptions for certain variable-rate paper), the portfolio's weighted average maturity cannot exceed 60 days, and its weighted average life cannot exceed 120 days (17 CFR 270.2a-7(d)(1)).

The rule also sets liquidity floors. A fund may not buy a security other than a weekly liquid asset if that leaves it under 50 percent of total assets in weekly liquid assets, and, except for tax-exempt funds, it may not buy a non-daily-liquid security if that leaves it under 25 percent in daily liquid assets (Rule 2a-7(d)(4)). It may not put more than 5 percent of assets in illiquid securities. The SEC's 2023 amendments raised those liquidity minimums.

A government money fund holds 99.5 percent or more of its assets in cash, government securities and fully collateralized repurchase agreements (Rule 2a-7(a)(14)). A prime fund is a money fund that is neither a government fund nor a tax-exempt one, so it may also hold corporate and other non-government short-term debt. That extra freedom is where its extra yield comes from, and where its credit risk comes from.

None of this is deposit insurance. The FDIC does not cover mutual funds, including money market funds, and the SEC says that investing in one carries a risk of losing some or all of your money.

Retail versus institutional prime: two different products

Rule 2a-7 splits prime funds by who owns them, and the split changes how the fund behaves under stress. A retail money market fund has policies designed to limit all beneficial owners to natural persons (Rule 2a-7(a)(21)). Government and retail funds may keep a stable share price using amortized cost or penny rounding. Institutional funds that are not government funds must compute their price to at least the fourth decimal place, which means it floats (Rule 2a-7(c)(1)).

The 2023 amendments changed the stress rules in three ways, according to the SEC fact sheet:

1. Funds can no longer suspend redemptions with temporary gates.
2. The link between a fund's weekly liquid assets and its liquidity fees was removed.
3. Institutional prime and institutional tax-exempt funds must impose a mandatory liquidity fee when net daily redemptions exceed 5 percent of net assets, unless the fund's liquidity costs are de minimis.

Non-government money funds, retail prime funds included, must institute a discretionary fee if the board decides it is in the fund's best interest, capped at 2 percent of the value of shares redeemed (Rule 2a-7(c)(2)(i)). Government funds are not required to impose either fee, but may opt in to the discretionary fee. The mandatory fee does not apply to government funds or to retail funds (Rule 2a-7(c)(2)(ii)).

On $50,000 of hypothetical redemptions, a fee at the 2 percent cap is $50,000 x 0.02 = $1,000. The cap is a ceiling. A mandatory fee is set from the fund's good-faith estimate of the cost of liquidity, so it can be much smaller.

What an ultra-short bond fund is not

An ultra-short bond fund is not a money market fund. The SEC states that its net asset value fluctuates while a money market fund tries to hold a stable $1.00, that it pursues higher yield by investing in securities with higher risk, and that some ultra-short funds may lose money despite an objective of preserving capital. The three risks the SEC names are the credit quality of holdings, their maturities, and interest rate sensitivity.

Because the fund does not call itself a money market fund, Rule 2a-7 does not apply to it. There is no 397-day cap and no 60-day weighted average maturity limit in the rule. The prospectus sets the fund's own limits, and they can allow longer or lower-rated holdings than a money fund would. Read three lines in the prospectus: the duration range, the minimum credit quality, and how much can sit below investment grade.

The product also comes in two wrappers. As a mutual fund it trades at end-of-day net asset value. As an ETF it trades all day on an exchange, and the SEC notes that an ETF's market price typically differs a little from its net asset value per share, a premium or discount, because supply, demand and creation costs move it.

The three costs of extra yield

Price risk from interest rates. Duration measures how far a fund's price is likely to move when rates move. The formula is the standard approximation: price change % = -duration x change in yield, where duration is in years and yield change is in percentage points. FINRA's own example is the long-duration case: a bond fund with a 10-year duration loses about 10 percent if rates rise 1 percent. Apply the same arithmetic to a hypothetical fund with 0.5 years of duration and a 1.00-point rise: 0.5 x 1.00% = 0.50%, or $500 on $100,000. It is an approximation, and it assumes a one-time parallel move.

Credit risk. Suppose 5 percent of a fund's holdings sit with an issuer whose paper is marked down 10 percent. The fund's price falls 0.05 x 0.10 = 0.50%, again $500 on $100,000. A downgrade does not need a default to cost you money.

Liquidity cost. In a stressed market you can pay through a fee, through a discount, or through both. A prime fund charges a fee, and an ETF sold at a discount charges you the gap. In a hypothetical case with a net asset value of $50.00 and a market price of $49.90, the discount is $0.10 / $50.00 = 0.20%, so selling $25,000 costs $50. A fund with a floating price shows you the loss in the price itself: 20,000 shares at $1.0000 are worth $20,000, and at $0.9950 they are worth $19,900, a $100 loss.

The recovery formula

The extra yield is pay for the risk, so measure the risk in months of that pay. Recovery months = price drop % / (extra yield % / 12). Here, price drop is the loss you are testing, and extra yield is the fund's yield minus the yield of the alternative you would otherwise hold, in percentage points per year. Both numbers are hypothetical here.

Take a government money fund at 4.00% and an ultra-short fund at 4.40%. The extra yield is 0.40 points, or $400 a year on $100,000, which is about $33.33 a month. Now test three shocks.

If the loss is larger than a year of extra yield, the fund's edge is negative for that year. A 0.50% drop is bigger than 0.40 points of yearly edge, so in a year with that shock the ultra-short fund ends behind the government fund by $100 (the $400 edge minus the $500 loss). The loss is not permanent in every case. If a rate rise is the only cause, the fund's holdings mature and reinvest at higher yields, which is why recovery is measured in months. A credit loss on a defaulted holding does not come back.

Where each product sits in the framework

A decision routine

1. Name the tier. Tier 1, one month of essential expenses with same-day access, stays in deposits. The reserve decides how much a temporary loss can cost you.
2. Choose your loss budget in dollars, such as $300 on a $60,000 reserve, which is 0.50%.
3. Read the fund's duration and credit limits, and convert them into a loss using price change = -duration x yield change. Add a credit-shock line like the 5 percent by 10 percent case above.
4. Compute the recovery months against the extra yield you are actually getting, and compare them with how long you would hold the money.
5. For a money fund, find out whether your share class is retail or institutional, and read what the prospectus says about liquidity fees. For an ETF, look at typical bid-ask spread and premium or discount before you buy.
6. If any test fails, hold the money in deposits or Treasury bills. Compare them in the Treasury bills chapter, which covers the guarantee they carry.

A fund that needs longer than your holding period to earn back a plausible shock is not paying you enough for the risk. For a comparison of specific products in this space, see the FFRHX, JAAA and SGOV article and the SGOV versus savings comparison.