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Do money markets protect your principal?

Dear Dr. Don,
If I put money into the money market, is there a chance that I could lose that principal?
-- Tyler Trade-off

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Dear Tyler,
It's easy to get confused about how safe your money market investments are, especially when the typical bank now offers both banking and brokerage services under the same roof.

The first distinction I make is whether the investment is classified as a deposit with the bank and is covered by FDIC insurance, or NCUSIF insurance if you're banking with a credit union. I classify these investments as "bank products," and they are insured up to the limits of that insured coverage. A money market account, or MMA, is an insured deposit just like a CD, checking or passbook savings account.

A money market mutual fund, or MMMF, is not a bank product and is not covered by deposit insurance. Instead, you are purchasing shares in a mutual fund that invests in money market securities. Money market investments are short-term debt obligations with a final maturity of less than one year. Shares of money market mutual funds are priced at $1 per share. The yield from the investment comes in the form of interest earnings, not capital gains from rising share prices.

Investment managers of money market mutual funds work very hard to not "break the buck" by keeping the value of a fund share at $1. A fund's investments can lose value, and that loss in value can cause the share price to decline -- breaking the buck.

The risk to principal with a money market mutual fund depends on the risk that the investment manager takes on in investing the money in the fund. A money market mutual fund can invest solely in obligations of the federal government that are considered to be virtually risk-free, or they can invest in the short-term debt of corporations and take on a measure of risk that the corporation won't repay that obligation. Funds with longer average maturities also have higher interest-rate risk.

Money market mutual funds are also delineated by whether they invest in taxable securities or tax-exempt municipal securities. With a taxable fund you will owe federal and state income taxes on the interest income, but with a tax-exempt fund you won't owe any federal income tax on the interest income and may or may not owe state and local income taxes on the interest income, depending on how the fund is invested and the tax laws of your state.

You can use Bankrate to compare rates both locally and nationally for money market accounts and money market mutual funds. The mutual funds are segregated by taxable and tax-exempt funds.

An FDIC- or NCUSIF-insured deposit with a bank or credit union is backed by the full faith and credit of the United States government, and you face no loss of principal. Deposits over the insurance limit carry some risk of loss.

Money market mutual funds that invest solely in U.S. government securities have minimal risk to principal but how the fund invests does impact the risk to principal.

Money market mutual fund investment managers work very hard to not break the buck, but the more risk you take on when investing, even when investing in short-term debt, the greater the possibility that you could lose principal.

Bankrate.com's corrections policy -- Posted: Jan. 10, 2006
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