Chapter 3: Types of Investments
Several different kinds of instruments are available in the money market. Although all of these share the common characteristics of low risk and short maturity periods, there are some differences that need to be understood in order to make a good investment decision in a money market instrument.
These are the most popular and also the safest money market instruments available. They are backed by the US Treasury and are considered as ‘zero risk’ investments because the US government has never failed to fulfill its financial obligations and is unlikely to do so in the foreseeable future.
T-Bills are available with typical maturity terms ranging from a month to a year. When an investor buys them, he pays an amount that is lower than the face value of the bill. At maturity, the face value is paid back to him. The difference between face value and his purchase price is his gain.
T-Bills can be bought through non-competitive bidding from the Treasury directly. Banks and brokers allow investors to buy T-Bills through both competitive and non-competitive biddings. Competitive bids require you to bid for the yield you want to get on maturity. There is no guarantee that your application will be approved when you make a competitive bid. A non-competitive bid is a guaranteed purchase of T-Bills, which will yield a specified return on maturity.
The investment in a T-Bill can be anywhere between $1,000 and $5 million. This allows investors with different capital levels to participate in the fixed income market. T-Bills can also be sold before redemption date.
Other debt products are also offered by the Treasury, like T Notes, TIPS (Treasury Inflation Protected Securities) and Bonds. These are relatively longer term products, ranging from 2 years in the case of Notes to 30 years in the case of TIPS and bonds, and are thus not a part of the money market.
Commercial Paper is a promissory note backed by the guarantee of an established corporation. The maturity of a CP may range from 30 days to a maximum of 270 days. Next to T-Bills, CPs are the most favored investment option for money market investors.
As with a T-Bill, an investor can purchase a CP at a discounted value. However, as the average minimum investment value is $100,000, small investors have to usually route their investments in CPs through money market funds.
CP is unsecured debt, but it is still considered very safe because of the credit worthiness and reputation of the organizations that normally issue these. Before you buy a commercial paper, you should assess the issuer’s credit rating and growth prospects. Typically, organizations issue CPs to raise funds for short-term expenses without going through the hassles and complexities of large bank loans. The company may choose to issue the CP directly or use a bank or dealer as an intermediary. Agencies like Standard & Poor’s and Moody’s list their credit ratings of various CPs in the market to help investors make the right choice.
A Certificate of Deposit, or CD, is a deposit backed by a federally chartered bank. The bank bases the CD on its deposits and pays the lender (investor) a pre-determined rate of interest during the life of the CD. Jumbo CDs with denominations higher than $100,000 yield better returns than lower denomination ones.
The term of CDs ranges from 3 months to five years. These can be bought from brokers or banks by paying them a fee in addition to the cost of the CD. CDs, though generally safe, are considered slightly riskier than T-Bills, which are backed directly by the government. But as it is a rare occurrence for a bank to default on its CDs, these can be included in an investment portfolio to reduce risk.
You can find CDs from many large banks. It is important to compare various aspects like interest, maturity date and the credit worthiness of the issuer when shopping for CDs. It is also possible to tap into higher interest rates outside the US by investing in Eurodollar CDs. Many money market funds invest in these high denomination loans to foreign banks in this manner. Eurodollars have to offer higher returns than domestic CDs because of the reduced liquidity and higher risk.
BAs are guarantees by a bank based on collateral. These generally arise out of a cross-border trade where a buyer needs to show evidence of his ability to pay. In this case, the buyer makes a promise to settle on a specified date the amount due for a particular quantity of goods offered by a seller. The bank issues an acceptance of the promise by means of the BA. If the buyer defaults, the bank can take possession of the goods. The seller sells the BA in the market and gets a price equivalent to the sale price of his goods. In exchange for the immediate availability of funds, the seller offers a discount on the BA’s redemption value.
Repurchase Agreements (Repos) are agreements to sell and buy back government securities like T-Bills. These agreements allow the seller to raise funds quickly for a very short term, say, a day to 30 days.
A holder of a T-Bill sells it to a lender with the condition that he will buy it back at a specified date at a predetermined price. The T-Bill yields the sale price to fulfill the immediate need and the seller builds up enough cash by buy back time to repurchase the bill. The transaction can be seen as a loan from the buyer with the T-Bill as collateral.
There are many instruments in the money market that let both big and small investors gain reasonable returns while keeping their investment safe. The market is quite versatile with many modifications and combinations possible with different instruments. This makes the money market a safe and flexible option for investors.