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The market environment clearly has changed: the era of ultra-low yields on liquid assets is over. Higher short-term interest rates, stimulative fiscal policies and business-friendly changes to the tax code have made tax-exempt money market funds more attractive for individual and institutional investors seeking to maximize returns while managing tax liabilities and maintaining liquidity.
Higher Yields Spark Demand for Tax-Exempt Instruments
Investors are focusing more intently on tax-exempt investments — including municipal money market funds — now that short-term interest rates are climbing. Investors who once paid little in taxes on the meager interest earned from taxable money market funds are seeing greater tax liabilities as yields increase, even at lower corporate tax rates. For those concerned about renewed tax burdens, now could be an opportune time to reallocate their assets into tax-exempt money market funds.
The need for tax-exempt income may be particularly strong in high-tax states, such as New York, New Jersey, Connecticut and California, where tax reform legislation curtailed the deductibility of state and local taxes. It makes sense that these taxpayers will seek alternative ways to manage their tax liabilities, including shifting income-producing assets to state-specific municipal bond and municipal money market funds.
Institutional investors will also strive to maximize their after-tax yields. Moreover, tax-exempt money market funds offer important diversification benefits for companies’ liquid assets. Highly liquid funds with short-weighted average maturities, strong credit characteristics and attractive after-tax yields should remain compelling alternatives for institutional investors.
The Shifting Dynamics of Supply and Demand
In addition to the impact of rising short-term interest rates, tax-exempt money market instruments have been greatly influenced by changing supply patterns.
During the fall of 2017, negotiations preceding the enactment of tax reform legislation produced dislocations in the market’s supply dynamics when municipal issuers rushed to issue $154.8 billion of longer term securities,1 including borrowings that had previously been slated for 2018 and 2019. As municipal bond yields increased, many investors sold tax-exempt money market instruments to raise capital for purchases of longer-term securities. In the midst of this selling pressure, the SIFMA Swap Index’s seven-day yield climbed as high as 1.71% at the end of last year.
So far in 2018, rising yields on U.S. Treasury obligations and steady investor demand have helped to drive the SIFMA Swap Index even higher.
Recent tax-exempt yield increases may be just the beginning of a longer-term trend. VRDN issuance volumes appear poised to increase as U.S. commercial banks convert some of their direct municipal loans to more cost-effective structures, including VRDNs. Furthermore, many issuers are looking for tax-advantaged alternatives to pre-refunded securities as a way to refinance longer-term debt. Finally, the need for massive infrastructure investment — and proposals to shift these costs to state and local governments — could further boost the supply of municipal securities, including at the short end of the market. As issuance volumes increase, tax-exempt money market yields seem likely to rise to compelling levels for individual investors and crossover buyers alike.
Tax-Free Money Market Fund Yields (December 2015 to Present)
In today’s new market environment, it has become increasingly clear that tax-exempt money market funds have an important role to play in the management of liquid assets. Dreyfus is a longstanding leader in the management of money market funds, and can help you achieve highly competitive returns while managing your tax liabilities, maintaining liquidity, adding diversification and preserving capital.