On a short-term basis, money market funds and short-term bonds are both excellent savings vehicles. Both are liquid, easily accessible, and relatively safe securities. However, these investments can involve fees, may lose value, and might decrease a person's purchasing power. Although money market funds and short-term bonds have many similarities, they also differ in several ways.
The money market is part of the fixed-income market that specializes in short-term debt securities that mature in less than one year. Most money market investments often mature in three months or less. Because of their quick maturity dates, these are considered cash investments. Money market securities are issued by governments, financial institutions, and large corporations as promises to repay debts. They are considered extremely safe and conservative, especially during volatile times. Access to the money market is typically obtained through money market mutual funds or a money market bank account. The assets of thousands of investors are pooled to buy money market securities on the investors’ behalf. Shares can be bought or sold as desired, often through check-writing privileges. A minimum balance is typically required, and a limited number of monthly transactions are allowed. The net asset value (NAV) typically stays around $1 per share, so only the yield fluctuates.
Because of the liquidity of the money market, lower returns are realized when compared to other investments. Purchasing power is limited, especially when inflation increases. If an account drops below the minimum balance required, or the number of monthly transactions is exceeded, a penalty may be assessed. With such limited returns, fees can take away much of the profit. Unless an account is opened at a bank or credit union, shares are not guaranteed by the Federal Deposit Insurance Corporation (FDIC), National Credit Union Administration (NCUA), or any other agency.
Bonds have much in common with money market securities. A bond is issued by a government or corporation as a promise to pay back money borrowed to finance specific projects and activities. In such cases, more money is needed than the average bank can provide, which is why organizations turn to the public for assistance. Buying a bond means giving the issuer a loan for a set duration. The issuer pays a predetermined interest rate at set intervals until the bond matures. At maturity, the issuer pays the bond’s face value. A higher interest rate generally means a higher risk of complete repayment with interest. Most bonds can be bought through a full service or discount brokerage. Government agencies sell government bonds online and deposit payments electronically. Some financial institutions also transact government securities with their clients.
Short-term bonds can be relatively low-risk, predictable income. Stronger returns can be realized when compared to money markets. Some bonds even come tax-free. A short-term bond offers a higher potential yield than money market funds. Bonds with quicker maturity rates are also typically less sensitive to increasing or decreasing interest rates than other securities. Buying and holding a bond until it is due means receiving the principal and interest according to the stated rate.
Bonds carry more risk than money market funds. A bond's lender may not be able to make interest or principal payments on time, or the bond may be paid off early with the remaining interest payments lost. If interest rates go down, the bond may be called, paid off, and reissued at a lower rate, resulting in lost income for the bond owner. If interest rates go up, the bond owner could lose money, in the sense of opportunity cost, by having the money tied up in the bond rather than invested elsewhere.
The Bottom Line
There are pros and cons to investing in money markets funds and short-term bonds. Money market accounts are excellent for emergency funds since account values typically remain stable or slightly increase in value. Furthermore, money is available when needed, and limited transactions discourage removing funds. Short-term bonds typically yield higher interest rates than money market funds, so the potential to earn more income over time is greater. Municipal bonds are tax exempt, saving high-income earners money. Overall, short-term bonds appear to be a better investment than money market funds.