Money Market vs. Short-Term Bonds: An Overview
Money market funds and short-term bonds have many similarities, but they also differ in several ways. They're both excellent savings vehicles on a short-term basis. Both are liquid, easily accessible, and relatively safe securities. But these investments can involve fees and they may lose value and decrease an investor's purchasing power.
Key Takeaways
- The money market is part of the fixed-income market that specializes in short-term government debt securities that mature in less than one year.
- Buying a bond is effectively giving the issuer a loan for a set duration; the issuer pays a predetermined interest rate at set intervals until the bond matures.
- Money markets are extremely low risk, with a typical par value of $1.
- Short-term bonds carry a greater degree of risk depending on the issuer, which may be a company, a government, or an agency.
Money Market Securities
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 mature in three months or less. These are considered to be cash investments because of their quick maturity dates.
Money market securities are issued by governments, financial institutions, and large corporations as promises to repay debts. They're 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 in which 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.
Lower returns are realized when compared to other investments because of the liquidity of the money market.
Purchasing power is limited, especially when inflation increases. A penalty may be assessed if an account drops below a minimum balance or if the number of monthly transactions is exceeded. Fees can take away much of the profit with such limited returns. Shares are not guaranteed by the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), or by any other agency unless an account is opened at a bank or credit union.
Short-Term Bonds
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. More money is necessary than the average bank can provide in such cases, which is why organizations turn to the public for assistance.
Buying a bond effectively means giving the issuer a loan for a set duration. The issuer pays a predetermined interest rate at set intervals until the bond matures. The issuer then pays back the bond’s face value at maturity. 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 predictable, low-risk 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 ratesthan other securities. Buying and holding a bond until it's due means receiving the principal and interest according to the stated rate.
The bond owner could lose money if interest rates go up, in the sense of opportunity cost by having the money tied up in the bond rather than invested elsewhere.
What Is the Safest Type of Money Market Fund?
Funds that hold a high concentration of government securities are considered by many to be the safest, particularly if they hold Treasuries, which are backed by the government and therefore carry a lesser risk of default.
What's the Difference Between a Short-Term and a Long-Term Bond?
A short-term bond will typically mature within no more than three years. A long-term bond may not mature until after 10 years. The bond's "coupon" or interest should be paid out a few times a year in either case. Deciding between them can depend on your goals and whether you're investing for the long-term or to achieve something that's on a closer horizon.
Which Is Safer, a Bond or a Money Market Fund?
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. The bond may be called, paid off, and reissued at a lower rate if interest rates go down, resulting in lost income for the bond owner.
The Bottom Line
There are both pros and cons to investing in money market funds and short-term bonds.
Money market accounts are excellent for emergency fundsbecause account values typically remain stable or slightly increase in value. Limited transactions discourage removing funds but the money is nonetheless available when it's needed. Short-term bonds typically yield higher interest rates than money market funds, so the potential to earn more income over time is greater.
Overall, short-term bonds appear to be a better investment than money market funds.
