Municipal money-market funds are missing out on record demand for cash as higher-yielding taxable products, volatile rates and fewer investment options make the niche sector less appealing for many retail buyers. 

With the Federal Reserve raising interest rates to the highest in 22 years, Treasuries headed for another annual loss and questions swirling around the outlook for stocks, the stability of taxable money-market funds that are yielding more than 5% has proved irresistible to many investors. Such assets have soared 18.3% through September to a record of about $6 trillion, according to Crane Data. Meanwhile, tax-exempt money-market funds have only grown 3.4%, reaching $122.9 billion.

What it boils down to is that yields on the muni offerings, which are lower because of the tax benefit they provide, simply aren’t compelling enough for buyers outside of the ultra-wealthy. The rates they offer also tend to be more volatile than on taxable options, complicating the comparison.

“The yields on munis just have not been attractive,” said Peter Crane, president of Crane Data, which tracks the money market-fund industry.

The average seven-day yield for tax-exempt money-market funds as of Oct. 6 is 3.12%, while the average for taxable products is 5.07%, Crane data show.

Given these yields, a taxable money-market fund might be the better buy for an individual investor with an all-in tax-rate below about 38.5%, according to Dean Tsantes, a financial planner at VLP Financial Advisors. Investors in the highest-tax bracket, however, may find more value in tax-exempt options.

Many retail investors who aren’t working with financial advisors might not understand the true value of the municipal market’s tax-exemption, especially because of the volatility in rates, further impacting demand. They could be focusing purely on absolute yields.

“It’s probably pretty easy for them to see 3.12% versus 5.07% and without really even considering the math, just jump into the taxable bonds,” Tsantes said.

Volatile Yields
The yield on the Securities Industry and Financial Markets Association Index, which tends to drive municipal money-fund yields, has bounced between 1.66% and 4.47% in 2023, according to data compiled by Bloomberg.

“The volatility of rates has fooled investors so many times,” Crane said. Investors are “just sick of muni funds showing a high rate one week and then by the time you move in, it’s gone.”

Joshua Perry, a portfolio manager on the fixed income team at Brown Advisory, said the quick changes in municipal yields can frustrate investors who are trying to figure out the most optimal investment after adjusting for taxes.

“If the taxable money market rates are high and stable and the tax-exempt money market rates are very volatile, and on a tax-equivalent basis, sometimes are better and sometimes are worse, you’d rather just not deal with the hassle and just leave your money somewhere that’s a lot more stable,” he said.

‘Handful of Players’
Consolidation in the industry also limits the growth for tax-exempt funds. Over the last two decades or so, near-zero interest rates and US Securities and Exchange Commission changes resulted in many funds closing or merging with others, shrinking the number of options.

“It’s pouring rain, and they’ve just got tiny buckets,” Crane said. “They’re benefiting, but they’re not the size they used to be, and they aren’t on the menus like they used to be. There’s only a handful of players now.”

At their peak in 2008, tax-exempt money-market fund assets approached roughly $520 billion. Today, they’re less than one-quarter of that, according to Investment Company Institute data.

To be sure, some tax-exempt fund managers say they are seeing healthy demand and that it’s hard to compare the muni niche with the larger money-market space.

“Taxables have a bigger investor base than we do,” said Mary Jo Ochson, chief investment officer of tax-exempt money-market funds at Federated Hermes. “Tax-exempt money market funds still make a lot of sense for individual investors in higher federal income tax brackets.” she said.

--With assistance from Amanda Albright, Alexandra Harris and Liz Capo McCormick.

This article was provided by Bloomberg News.