Investing Newbie asking few basic questions..... (bond, mutual funds, creditors, cash)

[srk007]

Hello,

I am an investing newbie. I am asking this on my parent's behalf who are considering to move to USA and investing. (Which will be eventually inherited by me , thus taking interest in this subject and learning basics)


1) What is a money market mutual fund or money market fund?

2) Income (interest, dividends) earned from the above funds are exempt from Federal taxes and AMT ?

3) What is the difference between money market mutual fund and municipal bonds ?

4) Returns of AMT-FREE Municipal bond ETFs are usually lower than than AMT-TAXED Municipal bonds?

5) What happens if a municipal bond defaults? Do investor loses 100% of the money invested?


Thanks for any help...

[eskercurve]

Originally Posted by srk007

Hello,

I am an investing newbie. I am asking this on my parent's behalf who are considering to move to USA and investing. (Which will be eventually inherited by me , thus taking interest in this subject and learning basics)


1) What is a money market mutual fund or money market fund?

A MMMF or MMF has a good description at Wikipedia: Money market fund - Wikipedia, the free encyclopedia

2) Income (interest, dividends) earned from the above funds are exempt from Federal taxes and AMT ?

Consult a tax advisor. I do not believe that these earnings are exempt from taxes unless they are invested in municipal bonds as part of the fund. The funds that you're talking about above may invest a portion of their assets into municipal bonds, which under IRS rules are tax-exempt. However, they may not be 100% tax exempt, because while the interest or dividends from those may be tax exempt, if they contribute substantially to your year end earnings, you may end up paying more in your Social Security taxes, and depending on which state you invest in or reside in, you may be subject to state income taxes too. In other words, if you earn $5,000 in tax-exempt dividends / interest and live in California, you will likely owe state income taxes on that and on top of that it will count towards your social security taxes.

To make things more complicated, if part of the fund is invested in muni's that are tax exempt, they will report those separately from the taxable dividends. So come tax time it is really confusing at times, thankfully most returns explain the differences very well nowadays.

3) What is the difference between money market mutual fund and municipal bonds ?

A MMMF is listed under an exchange as a mutual fund investing in a broad basket of assets, such as cash, Treasurys, government debt, corporate debt, municipal debt, etc. Municipal bonds are purely municipal debt issued by cities or counties or states to borrow money for various things such as closing revenue gaps, investing in large infrastructure projects, etc.

So, an MMMF may invest in some municipal bonds. You can think of it as a regular mutual fund with stocks - a mutual fund vs. a single stock.

In that same vein, MMMF's usually invest in a broad range of investment grade debt. Some cities have better bond ratings than other cities and pay less interest, and thus less returns for the investors, in exchange for stability. To boost gains, many invest in lower-rated debt that is at a higher interest rate, but at higher risk for default. That's much the same way with many mutual funds with stocks; except instead of stocks, they invest in mostly debt.

4) Returns of AMT-FREE Municipal bond ETFs are usually lower than than AMT-TAXED Municipal bonds?

Not necessarily true.

5) What happens if a municipal bond defaults? Do investor loses 100% of the money invested?


Thanks for any help...

When a muni bond defaults, a wide range of things may happen. The municipality may go to bankruptcy proceedings and the investors may lose everything. This is rare though.

Usually, a municipality would negotiate a reduced rate or negotiate with creditors to repay. Most who do this end up paying about 50 cents on the dollar and you get about 25 cents on your dollar, after legal fees.

Sometimes, a municipality will be absorbed by a more financially sound one and assume their debt in exchange for basically saying what may be mortgaged, and the former executors lose their jobs.

Other times as what happened in many places, they shut down services, sell off buildings and land, raise taxes, and do other things to raise the revenue to repay.

A lot of things can happen, but it is rare that they lose 100%


Given your folks are most likely very high net worth individuals (exceeding $10 million) and take a keen interest in their finances, ask them if you can listen in on discussing these issues with a tax advisor. They'll likely gladly let you do so if they're concerned for your future. Good luck!

[crescent22]

1) Very short-term interest instruments- prices vary so little that a fund based on them is always priced at 100% (rounded, so 99.5-100.5%) to the dollar. Most of them pay 0.01% right now. Basically no risk unless there is another financial crisis and even in 2008, only a couple had problems- paid off 97-99%.

2) Municipal money market funds are exempt. Regular ones are not.

3) 1 is a collection of short-term instruments that could be municipal. The other is a single bond. The term bond tends to mean an instrument over 1 year to maturity. Money market funds invest in instruments <1 yr.

4) AMT bonds tend to have higher yields because they are taxable and are issued by riskier entities (private ones like hospitals that are borrowing the government's backing). Returns are stated before any tax liabilities to the holders, so an AMT-free fund should have a rate of 0 while an AMT-taxed fund will have a small tax rate to those stuck in AMT.

5) Depends on who issued the bond. Also there are very very few municipal defaults historically. Direct obligations of a government will have high recovery rate as the government restructures its debt, so you get most of the money back but the price might go down while you wait as panickers sell. But some municipals are issued by separate entities like bridge tolls or industrial development - if the revenues do not come through, you can have a default and low recoveries. Most people invest in muni funds to rid themselves of concentration risk but the funds charge a 0.5-1.0% per year fee for the service.

The interest on all these is so low it's ridiculous. You have to go out 15+ years in municipals to get a rate that surpasses inflation now, and that 15+ years means there is quite a bit of price risk if interest rates go up.

[dude_reino]

A money market fund is basically a placeholder for the cash you're keeping on the sidelines. It is kept through your investment account, so when you want to buy an equity, you move cash out of your MM, and the opposite when you sell.

It is no different than a savings account, except that you would have to physically transfer the cash between your savings account and your investment account every time you wanted to buy an equity. MM eliminates that extra step.