The money market is better known as a place for large institutions and government to manage their short-term cash needs. However, individual investors have access to the market through a variety of different securities. In this tutorial, we'll cover various types of money market securities and how they can work in your portfolio.
The money market is a subsection of the fixed income market. We generally think of the term fixed income as being synonymous to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that the money market specializes in very short-term debt securities (debt that matures in less than one year). Money market investments are also called cash investments because of their short maturities.
Money market securities are essentially IOUs issued by governments, financial institutions and large corporations. These instruments are very liquid and considered extraordinarily safe. Because they are extremely conservative, money market securities offer significantly lower returns than most other securities.
One of the main differences between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for the individual investor. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to acts as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.
The easiest way for us to gain access to the money market is with a money market mutual funds, or sometimes through a money market bank account. These accounts and funds pool together the assets of thousands of investors in order to buy the money market securities on their behalf. However, some money market instruments, like Treasury bills, may be purchased directly. Failing that, they can be acquired through other large financial institutions with direct access to these markets.
There are several different instruments in the money market, offering different returns and different risks. In the following sections, we'll take a look at the major money market instruments.
Treasury Bills
Treasury Bills (T-bills) are the most marketable money market security. Their popularity is mainly due to their simplicity. Essentially, T-bills are a way for the U.S. government to raise money from the public. In this tutorial, we are referring to T-bills issued by the U.S. government, but many other governments issue T-bills in a similar fashion.
T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay interest semi-annually.
Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you'll receive the full amount of the security you want at the return determined at the auction. With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for. (More information on auctions is available at the TreasuryDirect website.)
The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other positives are that T-bills (and all Treasuries) are considered to be the safest investments in the world because the U.S. government backs them. In fact, they are considered risk-free. Furthermore, they are exempt from state and local taxes. (For more on this, see Why do commercial bills have higher yields than T-bills?)
The only downside to T-bills is that you won't get a great return because Treasuries are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest. What's more, you might not get back all of your investment if you cash out before the maturity date.
T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. T-bills are purchased for a price that is less than their par (face) value; when they mature, the government pays the holder the full par value. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity. For example, if you bought a 90-day T-bill at $9,800 and held it until maturity, you would earn $200 on your investment. This differs from coupon bonds, which pay interest semi-annually.
Treasury bills (as well as notes and bonds) are issued through a competitive bidding process at auctions. If you want to buy a T-bill, you submit a bid that is prepared either non-competitively or competitively. In non-competitive bidding, you'll receive the full amount of the security you want at the return determined at the auction. With competitive bidding, you have to specify the return that you would like to receive. If the return you specify is too high, you might not receive any securities, or just a portion of what you bid for. (More information on auctions is available at the TreasuryDirect website.)
The biggest reasons that T-Bills are so popular is that they are one of the few money market instruments that are affordable to the individual investors. T-bills are usually issued in denominations of $1,000, $5,000, $10,000, $25,000, $50,000, $100,000 and $1 million. Other positives are that T-bills (and all Treasuries) are considered to be the safest investments in the world because the U.S. government backs them. In fact, they are considered risk-free. Furthermore, they are exempt from state and local taxes. (For more on this, see Why do commercial bills have higher yields than T-bills?)
The only downside to T-bills is that you won't get a great return because Treasuries are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest. What's more, you might not get back all of your investment if you cash out before the maturity date.
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