How money market funds work

A money market fund is a mutual fund whose portfolio is built from short-term debt. Government funds hold Treasury bills, agency obligations and repurchase agreements backed by government securities. Prime funds can also hold commercial paper and bank obligations. Tax-exempt funds hold short-term municipal debt.

The portfolio turns many instruments with different maturity dates into redeemable fund shares. Securities mature continually, cash returns to the fund and managers buy new short-term instruments at current rates. That rolling process is why the fund's yield follows short-term interest rates with a lag rather than staying fixed for a term.

United States money market funds operate under rules on credit quality, portfolio maturity, diversification and liquid assets. Those constraints are designed to keep price movement small and redemptions fundable. They do not transform the securities into bank deposits.

Income reaches shareholders as dividends, commonly accrued daily and distributed monthly. Reinvesting those distributions buys more shares. Taking them in cash leaves the share count unchanged. The portfolio yield drives the income either way.

Net asset value, or NAV, is portfolio assets minus liabilities divided by shares outstanding. Many government and retail money market funds use amortized-cost accounting and rounding to seek a stable NAV of 1.00, so one share is intended to remain worth one dollar.

That 1.00 target is a convention, not a promise from a bank or the government. If portfolio losses exceed the cushion created by short maturities, quality rules and rounding, a stable-value fund can break the buck and redeem below one dollar a share. The event is rare, but the legal possibility separates a fund share from an insured deposit.

Some money market funds use a floating NAV instead. Institutional prime and institutional tax-exempt funds generally transact at a market-based value carried beyond two decimal places. Their share price can move in small increments even in ordinary markets.

A stable NAV also does not mean a stable return. The share price may stay at 1.00 while the dividend yield rises or falls. Price stability and income stability are separate properties.

A fund's seven-day yield takes the net income earned over a recent seven-day window and annualizes it under a standardized method. Expenses are already deducted, which makes the published fund yield a net portfolio-income measure before the shareholder's taxes. It is a backward-looking rate, not a rate locked for the coming year.

For a one-year illustration, the growth identity is APY-shaped:

$$V = P(1+y)$$

$P$ is the starting balance, $y$ is the annual yield held constant and $V$ is the ending value with distributions reinvested. At 5 percent, $10,000 becomes $10,500, of which $500 is income. At 4 percent, the same $10,000 becomes $10,400, including $400 of income.

A real fund replaces maturing securities throughout the year, so $y$ changes. The illustration answers what a constant annual yield would do, not what a current seven-day quote promises. The APR against APY calculator shows the compounding shape, and how APR and APY work separates a quoted rate from a rate that already includes compounding.

Expense ratios matter directly because they are subtracted before shareholders receive the yield. A fee waiver can raise the current net yield and can later expire under the prospectus terms, so comparing funds means reading both the net yield and the expense arrangement.

The word money market describes the maturity range, not one identical portfolio. A government fund emphasizes government securities and qualifying repurchase agreements. A Treasury fund is narrower, concentrating on Treasury obligations and related holdings. A prime fund can lend to companies and banks through commercial paper and certificates. A tax-exempt fund lends to municipal issuers.

The broader credit set in a prime fund can pay a higher yield because shareholders accept private credit and liquidity risk. That spread is compensation for a different portfolio, not free return. A government fund can still face interest-rate, liquidity and operational risks even when its securities carry little credit risk.

Tax treatment follows the income source and the shareholder's jurisdiction. Interest attributable to direct Treasury obligations can qualify for state and local tax relief when reporting conditions are met. Municipal income can qualify for federal tax exemption, while gains, nonqualifying holdings and state rules can produce a different result. The tax label belongs to the actual portfolio and tax report.

Comparing funds begins with portfolio type, then net yield, expenses, redemption terms and tax treatment. Yield is income relative to the amount invested. A larger yield is meaningful only after identifying which risks and taxes changed with it.

Money market fund shares are designed for frequent redemption. Many brokerage platforms allow same-day trading and quick settlement, and some attach cheque or card features. That access can make the shares function like transaction cash inside a portfolio.

Legally, the shareholder owns fund shares. FDIC insurance does not cover the fund merely because a bank or broker sells it. Securities Investor Protection Corporation protection at a brokerage concerns missing customer property if the broker fails, not a decline in the fund's NAV.

Stress rules can also affect redemptions. A fund can use a liquidity fee under specified conditions so redeeming shareholders bear more of the cost of raising cash. Liquidation remains possible if a fund cannot continue. The prospectus identifies the fund's redemption and fee framework.

That distinction is why a money market deposit account and a money market fund should not be substituted by name. Savings account types covers the insured deposit. A money market fund offers market-based income and high liquidity through a mutual-fund share.

The examples hold one annual yield constant for one year and reinvest the income once at year-end. The 5 percent case grows $10,000 to $10,500 and attributes $500 to income. The 4 percent case grows $10,000 to $10,400 and attributes $400 to income.

A published seven-day yield changes as the portfolio rolls into new securities. Daily accrual and monthly reinvestment can alter the path slightly, while taxes alter what the shareholder keeps. The examples isolate the annualized yield relationship so two rates can be compared on the same starting balance.

A fund's prospectus and current report identify portfolio type, net yield, expenses, NAV method and redemption terms. This is educational material, not financial advice.