Cash management using municipal resets instead of MMF

Abstract

Many people keep their liquid holdings in the bank or in a money market fund. If you are in a high tax bracket, municipal reset bonds represent an attractive alternative vehicle in place of money market funds. The main advantage with municipal reset bonds is that typically you can get yields that are the same or very close to that obtained by institutional money market funds. The disadvantage is that you lose some liquidity and have some diversification risk.

For various reasons, I am keeping quite a big chunk of cash in MMFs (money market funds). These are mostly invested in FSPXX (Fidelity’s CA AMT-free MMF) and VCTXX (Vanguard CA MMF).

Recently, I started looking into using municipal reset bonds (resets for short) for cash management instead of using MMFs. For those new to resets, resets belong to the class of Auction Rate Security (ARS). This information page from Fidelity is a good starting point to read up more on ARS. Here are some excerpts:

Municipal resets belong to a class of bonds known as Auction Rate Securities whose coupon rates are periodically reset through auctions held every 7, 14, 28 and 35 days. Some bonds even reset daily although in these cases interest is paid out monthly with accrued interest.

Although the rates are reset frequently through an auction process, the underlying municipal bond may be issued with a maturity lasting anywhere from 5 to 30 years. Municipal resets were introduced primarily as an institutional product and over time more retail investors have begun to participate in the auction process.

Investors should pay close attention to the minimum required investment which is typically $25,000.

Benefits of Municipal Resets

  • Issued at par, sell at par – only when selling on the reset date.
  • Frequent and predictable windows to enter and exit the position.
  • A product whose coupon automatically regularly adjusts in keeping with the increases and decreases of short-term market interest rates.
  • Frequent stream of coupon payments.

Risks and Considerations

  • Limited diversification: Although short-term securities are typically associated with less volatility and risk, they rarely provide the same return opportunities as longer-dated bonds over an extended period.
  • Limited liquidity: Orders must be placed from 7am – 11am ET on the day of reset. With bonds that reset daily, the time is reduced to between 7am – 10am ET. Orders cannot be accepted before these times and if sent will not be considered for the auction.
  • Failed auctions: Can occur when the auction agent does not receive sufficient bids below the maximum rate. When an auction fails, the rate is set at the maximum rate. The maximum rate is often a multiple of a reference rate such as LIBOR or an index of Treasury securities.

Pros and cons (my take)

Basically, from what I can gather, the main pro in using resets is the higher yield. On this date, the yield after AMT using MMFs is around 3.5% APY while I can get an after AMT rate of ~3.6% rate for resets. This is equivalent to an APY of ~3.7%, i.e. I gain around 20 basis points in after tax yield. Note: resets are quoted in “coupon rate” and must be converted to APY to compare with MMF yield.

Intuitively, I expect there will always be a spread of around 20 to 30 basis points in yield from MMF to resets, because of the following reasons:

  • expense ratio of the MMF, which typically ranges from 0.15% to 0.4%,
  • compensation for the slight loss in liquidity and diversification, and
  • because resets as a whole is a relatively unknown and “more complex” cash management vehicle for retail investors.

The cons are :

  1. Less liquidity (if I need to liquidate on a non-reset day, I might experience a loss in principal or it might not be possible at all). Also I don’t have the convenience of writing checks against a MMF. But if I were to buy, I would typically go for 7-day resets. A 7-day reset is a very short time that I can live with.
  2. Less diversified than a MMF since typically a minimum of $25k is allocated to one issuer.

Factors that help to mitigate diversification risk

  1. If there is a downgrade in credit quality, I can get out in not more than 7 days. Defaults typically happen only following a series of downgrades and this can only happen in a much longer time period than 7 days.
  2. Pick issues backed by different insurers and bonds in different sectors of the economy.
  3. According to quotes from the FWF post (see resources below), there has never been a default in VRS in the 20-year history.
  4. Many finance writers feel safe with using AAA municipal bonds, especially those that are ‘natural’ AAA, and not inherited due to insurance. Also, in general AAA municipals are many times safer than AAA corporates.

Purchasing information

Unless you have a private banking relationship with a bank, the best place for retail investors to get resets is probably through Fidelity. According to a reply from a Fidelity, there is “no fees/commissions for purchasing and selling municipal resets. You can do this through your Fidelity Account at no charge.”

One thing to note though is that at Fidelity, currently “orders may only be placed on the day of the auction between the hours of 7am – 11am ET and for those securities that reset on a daily basis between 7am – 10am ET.” Also, only buy orders may be placed online; sale or hold orders must be done through a representative on the phone at 800-544-5372.

Things to consider

Since my intention is to use resets to replace the bulk of my MMFs, the following are the considerations I have.

  1. Only AAA-rated resets and try to diversify across different insurers in different badges.
  2. Only federal, state and AMT tax free resets.
  3. Only 1-day or 7-day resets.

Additional web resources

Link to Fidelity’s inventory of municipal resets.

Link to Smith Barney’s ARS page.

Dolmar’s post on ARS at FWF — this is the post that got me started on municipal resets. Thanks Dolmar!

My post on the Bogleheads forum.

InvestingInBonds.com CUSIP search.

Random list of previous posts:

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    One Response to “Cash management using municipal resets instead of MMF”

    1. indexfundfan Says:

      Just to correct a misconception on municipal resets.

      After you purchase a reset, there is nothing more that you need to do. You do not have to manually rollover every week, i.e. no buying or selling each week. What happens every week is that you get paid and the rate resets. Of course if you want, you can put a hold-bid order every week at a specific minimum yield but this is completely optional.