By Vikash Agarwal
Whenever a bear market comes along, investors realise that the stock market is a risky place for their savings. It’s a fact that we tend to forget about the higher returns enjoyed during a bull market. Unfortunately, this is part of the risk-return tradeoff. To get higher returns, you have to take on a higher level of risk. For many investors, a volatile market is too much to stomach. Then, money market offers an alternative to these kind of investors.
The money market is better known as a place for large institutions and government agencies to manage their short-term cash needs. The money market is a subsection of the fixed income market. We generally equate term fixed income to bonds. In reality, a bond is just one type of fixed income security. The difference between the money market and the bond market is that money market specialises in very short-term debt securities. Money market investments are also called cash investments because of their short-term maturities.
Money market securities are essentially issued by governments, financial institutions and large corporations. These instruments are very liquid and considered as extraordinarily safe. Because they are extremely conservative. One striking feature of money market securities is that they offer significantly lower returns than most other securities.
One of the main difference between the money market and the stock market is that most money market securities trade in very high denominations. This limits access for small and retail investors. Furthermore, the money market is a dealer market, which means that firms buy and sell securities in their own accounts, at their own risk. Compare this to the stock market where a broker receives commission to act as an agent, while the investor takes the risk of holding the stock. Another characteristic of a dealer market is the lack of a central trading floor or exchange. Deals are transacted over the phone or through electronic systems.
The easiest way for us to gain access to the money market is through money market mutual funds. These funds pool together assets of thousands of investors in order to buy the money market securities on their behalf. There are several different instruments in the money market, offering different returns and different risks.
Treasury Bills (T-bills) are the most marketable money market securities. Their popularity is mainly due to their simplicity. Essentially, T-bills provide a route for the Indian government to raise money from the public. T-bills are short-term securities that mature in one year or less from their issue date. They are issued with three-month, six-month and one-year maturities. Effectively, your interest is the difference between the purchase price of the security and what you get at maturity.
The biggest reason that T-Bills are so popular is that they are one of the few money market instruments that are affordable to individual investors. The only downside to T-bills is that you won’t get a great return because treasuries are exceptionally safe. Corporate bonds, certificates of deposit and money market funds will often give higher rates of interest.
A certificate of deposit (CD) is a time deposit with a bank. CDs are generally issued by commercial banks but they can be bought through brokerages. They bear a specific maturity date (from three months to five years), a specified interest rate, and can be issued in any denomination, much like bonds. Like all time deposits, the funds may not be withdrawn on demand like those in a checking account.
CDs offer a slightly higher yield than T-Bills because of the slightly higher default risk for a bank but, overall, the likelihood that a large bank will go broke is pretty slim. Of course, the amount of interest you earn depends on a number of other factors such as the current interest rate environment, how much money you invest, the length of time and the particular bank you choose. While nearly every bank offers CDs, the rates are rarely competitive, so it’s important to shop around. The main advantage of CDs is their relative safety and the ability to know your return ahead of time.
(The writer is an investment consultant based in Rourkela)