Rate cuts pummel money market funds

Low interest rates and high fees have driven yields on two small broker-sold money market funds below 1% — and more funds will follow if the Federal Reserve cuts rates again.

Some funds now collect more money in expenses than they pay investors. That hasn't happened since 2001.

One of the funds whose yield has fallen below 1%, BB&T U.S. Treasury money market fund, charges 1.43% in expenses and pays a seven-day simple yield of just 0.88%, according to iMoney.net, which tracks the funds.

The other, Merrill Lynch WCMA Treasury fund (class 1), charges 1.5% and yields 0.95%, according to iMoney.net.

Right now, the average taxable money fund yields 2.78%. (The average money fund yield dipped to an all-time low of 0.5% on April 27, 2004.)

Money funds invest in short-term, high-quality IOUs and distribute the interest to investors. When the Fed reduces rates, the yields of money funds tumble, too. The Fed has cut its key federal funds rate five times, to 3%, since September.

Thanks to the credit crunch, funds that specialize in Treasury securities have seen their yields fall faster than other funds. Those yields have been driven down by rising demand for ultrasafe Treasuries from investors fearful of defaults. Higher investor demand lets the government sell those T-bills at lower interest rates. That saves taxpayers money, but it leaves investors with puny yields. A three-month T-bill now yields just 1.46%.

Funds with the highest expense ratios have seen the sharpest declines in yields. Typically, broker-sold B and C share classes have the highest expenses, because they impose up to 1% for marketing and distribution costs, beyond the cost of managing the fund. The average fund charges 0.55% in expenses.

"It's a good time to look at your expenses," says Peter Crane of Money Fund Intelligence, which tracks the funds. Vanguard Treasury Money Market fund is one top performer: It has a 0.24% expense ratio and yields 2.88%.

Money funds that invest in securities other than Treasuries, such as bank CDs and repurchase agreements, often pay higher yields and entail minimally higher risks. Still, the credit crunch has magnified those risks. Legg Mason said last week that it's acquired a $150 million letter of credit to prop up one of its money funds. The fund had invested in a troubled structured investment vehicle, or SIV — a complex interest-bearing security.

The top-yielding fund for individual investors, Dreyfus Basic Money fund, yields 3.66%. The fund, which waives some of its costs, charges 0.45% a year in fees.

Yields will fall further if the Fed cuts rates again Tuesday. Despite low yields, investors have poured cash into money funds — $22 billion last week alone.