One of the most popular recent investment ideas is the money market mutual fund for parking short-term cash. Another has been the tax-exempt mutual fund that passes tax-exempt interest from municipal bonds to shareholders. If two ideas are good separately, why not combine them?
Short-term tax-exempt mutual funds appeared less than a year ago with some characteristics of both types -- daily earnings, check withdrawal, reasonably stable net asset value, and substantial tax-free yields. In the case of the money market funds, the yields have increased as inflation built up to the 13-18 percent range. Rates are considerably less for the tax-exempt funds and currently range from 5 to 6 percent.
But other substantial differences remain. While maturities of instruments in money market mutual funds range from 16 to 35 days typically, the short-term tax-exempt funds keep maturities short by selecting municipal bonds close to maturity. Ordinarily, bond prices move up and down in opposite directions to interest rates. The net asset values (NAV) of bond funds, including the tax-exempt funds, declined recently as interest rates rose. Such price declines may wipe out income gains if bonds should be sold when prices are down.
By selecting only tax-exempt municipal bonds close to maturity, the funds keep the net asset value stable, and the interest yields remains as known value. Other tactics, such as agreements to resell bonds to the sellers in case of heavy bond redemptions, also help to keep share prices of the short-term tax-exempt bond funds stable. As a result, the short-term tax-exempt mutual funds offer a parking place for cash without incurring federal taxes. However, state income taxes may apply to all or part of the income depending on the makeup of the fund's portfolio.
Two points are worth considering before investing substantial cash in the new and appealing short-term tax-exempt mutual funds:
* Relative earnings from tax-exempt and taxable funds should be compared. If a money market mutual fund delivers 14 percent yield and your marginal tax bracket (top percentage applied to your income) is 50 percent, your after-tax income is 7 percent. A recent net return from one short-term tax-exempt fun was 5.3 percent. With a 14-percent taxable yield available, your marginal tax bracket would have to exceed 62 percent before the tax-free return was comparable. While tax-free income holds a certain appeal, looking at the number of dollars you have left to spend from both approaches tells you which course makes more sense.
* Avoiding any change of net asset value is important for the investor who trades frequently or a person who wishes to receive earnings from funds parked between investments. High tax bracket investors may find the short-term tax-free funds useful for that purpose. But, recognizing the relationship between interest rates and bond prices, including prices of municipal bonds, can lead to tax-free income plus long-term capital gains.
"Moneywise" has previously suggested getting into long-term discount bonds when interest rates are high. Later, when interest rates decline, bond prices recover and provide long-term capital gains (when bonds are held for one year or longer). Thus, investing in a regular tax-free bond fund could yield more total income than investing in short term tax-exempt fund when interest rates are high.
Several short-term tax-exempt mutual funds have appeared recently, and more are apparently on their way. Minimum initial investments tend to be high -- $20 ,000 for one fund.