Yields soar on tax-free money market mutual funds

The recent run on money market mutual funds has had the temporary side effect of sending yields soaring on tax-free municipal money market funds. As of Oct. 1, the Vanguard Tax-Exempt Money Market Fund (VMSXX) was paying 5.83 percent. For someone in the 28 percent tax bracket, that would be the equivalent of earning 8.1 percent.

This isn't due to a decline in the quality of the short-term municipal bonds these funds hold. It's a result of the mass redemptions in money market funds that took place when worries arose about their safety. (Not to be confused with bank money market accounts—which are FDIC insured—money market mutual funds are not insured but are regulated to invest in short-term, generally safe securities.) Short-term municipal bonds are safer than the Lehman Brothers bonds that got a taxable money fund into trouble. But the industry-wide redemptions forced the financial firms that market short-term municipal securities for state and local governments to offer them at higher yields to create greater demand for them.

However, these high rates aren't expected to last. Matt Fabian, the managing director at Municipal Market Advisors, a muni bond research firm, expects these rates to subside after a month or so, but remain above average for this year.

Greg McBride, senior financial analyst at Bankrate.com, agrees and says that you should be prepared to move your money elsewhere, such as a high-yield savings account, when yields return to earth. He notes that any new money put into these types of funds won't be covered under the U.S. Treasury guarantee program, a plan recently introduced to insure money market fund share prices.

For this reason, if you put money into a tax-free money market fund, it's advisable to stick with one of the larger fund companies, like Fidelity, T. Rowe Price, or Vanguard. "Fund management has become much more difficult in the turmoil, and a larger pool of invested assets gives the fund manager more flexibility that he or she can use to protect the money market investor," Fabian says. State-specific tax-free money market funds may make sense if you pay state tax. —Chris Fichera