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Your Money | PERSONAL FINANCE / CHARLES A. JAFFE

Insurance Against a Money Fund Not Doing Its Job? Don't Think So

September 04, 1996|CHARLES A. JAFFE

Financial advisors generally recommend getting insurance coverage only for those things you can't afford to replace.

Applying that logic to money market mutual funds, the idea of paying fund companies to buy insurance to protect against bond defaults probably doesn't pass the smell test.

In case you've missed it, there are changes afoot in companies that offer money market funds. Fidelity Investments recently sought regulatory approval to start an insurance company that would protect its money market funds from losses caused by defaults among issuers of money market securities.

Marsh & McLennan, the parent company of Putnam Investments, quickly followed suit and said it would offer similar protection to money fund managers. Several other insurers, including the major groups that insure municipal bonds, will probably offer similar programs in the next few weeks.

The idea of insuring money fund managers against credit risk is not new. Most fund groups have explored coverage, only to reject it as too costly. But as the potential price comes down--and with investors footing the bill--that stance is changing.

Money market mutual fund shares are supposed to maintain a constant price of $1. Each day a fund's holdings are "marked to market," meaning that the value of securities is confirmed at current market prices; if the bond market were to crumble or a fund has a big holding in an issue that goes kablooey, the value of the fund's holdings could fall below $1 per share.

That is known as "breaking the buck," and it has happened just once in recent memory, with a small institutional fund too inconsequential for the big boys to bail out.

Every company that runs money funds says it will never break the buck. Clearly, those words are no guarantee, but allowing the share value to fall below $1 would be a public relations nightmare, effectively ruining a firm's good name.

That's why dozens of fund advisors bailed out money funds when Orange County declared bankruptcy and had a credit erosion that hurt everyone holding its paper. It's why the fund groups stand ready to bail out their funds again today.

That pressure to uphold the standard essentially functions as implied liability insurance. Given the extremely low likelihood of money market securities defaults, this is a measure of safety you pay for when buying the fund in the first place.

Essentially, the insurance now under consideration protects the fund group if a bailout is necessary. It does not pay customers, nor does it create a form of deposit guarantee such as what consumers get with a federally insured bank account.

In other words, fund groups plan to bail out investors if disaster strikes--and in fact must make good or face the ruin of their business--but want consumers to pay for the privilege of covering the fund group's potential losses.

"Maybe the fund groups need this, but the ordinary investor really doesn't," says Richard Lehmann, president of the Bond Investors Assn., which tracks bond defaults. "If it provides a comfort to people, then it's a good marketing gimmick. But in no way is it a necessity."

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Executives at various fund groups say the new insurance "guarantees" the bailout of a troubled money fund. That still rings hollow, given that the maximum coverage is $100 million. Fidelity's money market portfolio is some 800 times bigger than that--and other fund groups have multibillion-dollar holdings--so this is a guarantee against minor market problems only.

In addition, limits on what money funds can buy are very strict, and funds already carry insurance in case a manager turns psycho, goes outside the lines and blows up the portfolio. If a fund is managed so it won't break the buck--a standard every fund group claims to follow--credit risk is minimal.

The insurance will raise a fund's expenses, which lowers returns. In Fidelity's case, the estimated expenses hike would be no more than 0.01 percentage point. For smaller fund groups, the cost of the insurance could amount to 0.05 point.

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That may not seem like much until you consider the spread between the average high-quality money fund--now returning 4.73%--and the average money fund invested entirely in U.S. Treasuries, which, according to IBC Financial Data, is yielding 4.61%. The fund with the Treasury paper is insured by the full faith and credit of the government, which is a far sight better than the default insurance the industry is mulling over.

The thinner the spread between an all-Treasury fund and its hybrid counterparts, the easier it is for average investors who fear the collapse of the money markets--a fear most experts don't share--to get maximum peace of mind by limiting their money market choices to Treasury-only funds.

"This insurance doesn't do much except polish a fund's image--and I'm not sure I want to pay for that," says Ralph "Chip" Norton, editor of IBC Financial Data's Bond Fund Report. "It's their job not to break the buck, and I'm not sure I should have to pay because they are afraid they can't get it right."

Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.

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