Money Market Funds: Government, Prime and Tax-Exempt

Why This Topic Matters for the CTP Exam
Money market funds (MMFs) are among the most widely used short-term investment vehicles in corporate treasury. Treasury professionals rely on them daily to park operating cash, meet same-day liquidity needs, diversify counterparty exposure and earn a return on balances that would otherwise sit idle in a bank account. Because of this, the AFP CTP exam (within the Corporate Liquidity Management and Working Capital/Investment domains) routinely tests your ability to distinguish the three principal fund categories, understand how SEC Rule 2a-7 shapes their risk profile, and apply this knowledge to investment policy decisions, cash segmentation strategies and after-tax yield comparisons. A candidate who understands why a government fund behaves differently from a prime fund during market stress, and how a tax-exempt fund yield must be adjusted before comparison, will pick up several reliable points on exam day.

What Is a Money Market Fund?
A money market fund is an open-end mutual fund registered under the Investment Company Act of 1940 that invests exclusively in short-term, high-quality, highly liquid debt instruments. In the United States, MMFs are governed by SEC Rule 2a-7, which sets strict limits on portfolio maturity, credit quality, diversification and liquidity. The traditional objective of an MMF is to preserve principal, provide daily liquidity and generate a money-market rate of return, historically expressed as maintaining a stable net asset value (NAV) of $1.00 per share. Since the 2014 and 2023 SEC reforms, however, some fund categories are required to use a floating NAV that fluctuates with the market value of the portfolio.

Key structural features every candidate should know:
• Open-end structure: investors buy and redeem shares directly from the fund at NAV, typically with same-day or next-day settlement.
• Amortized cost accounting: stable-NAV funds value holdings at amortized cost rather than market value, which allows them to transact at $1.00 as long as the shadow (market) price stays within one-half cent of $1.00.
• Mark-to-market accounting: floating-NAV funds price shares to four decimal places (for example, $1.0002 or $0.9998).
• Breaking the buck: the event in which a stable-NAV fund's market value falls below $0.995, forcing it to reprice below $1.00. The Reserve Primary Fund did this in September 2008 after Lehman Brothers failed, triggering the regulatory reforms that followed.

Rule 2a-7 Requirements (Post-2023 Reforms)
The exam expects you to recognize these quantitative limits:
• Weighted Average Maturity (WAM): 60 days or less.
• Weighted Average Life (WAL): 120 days or less.
• Maximum maturity of any individual security: 397 days.
• Daily liquid assets: at least 25% of total assets (raised from 10% in 2023).
• Weekly liquid assets: at least 50% of total assets (raised from 30% in 2023).
• Diversification: generally no more than 5% of assets in any single issuer (with exceptions for government securities and short-term repos).
• Credit quality: securities must present minimal credit risk as determined by the fund board or adviser.
• Stress testing and disclosure: funds must stress test portfolios and report holdings monthly on Form N-MFP.
• Redemption gates: eliminated by the 2023 reforms; funds may no longer suspend redemptions through gates.
• Liquidity fees: institutional prime and institutional tax-exempt funds must impose a mandatory liquidity fee when daily net redemptions exceed 5% of net assets (unless the cost of liquidity is de minimis, under 0.01%). All non-government funds may impose a discretionary fee if the board deems it in shareholders' best interest. Government funds are exempt from these requirements unless they opt in.

The Three Main Categories

1. Government Money Market Funds
Government MMFs must invest at least 99.5% of total assets in cash, U.S. government securities (Treasuries and federal agency obligations) and repurchase agreements fully collateralized by cash or government securities. A subset, Treasury-only funds, restricts holdings to direct Treasury obligations and Treasury-backed repos.
• NAV: stable $1.00 for both retail and institutional investors.
• Credit risk: minimal; backed by the full faith and credit of the U.S. government or by agencies with implicit support.
• Yield: typically the lowest of the three categories because of the superior credit quality.
• Liquidity fees: not required; most government funds have elected not to adopt them.
• Tax treatment: income is subject to federal tax; income from direct Treasury obligations is generally exempt from state and local income tax, which makes Treasury-only funds attractive to investors in high-tax states.
• Treasury role: the default choice for operating cash, for investors who must avoid floating NAV and liquidity fees, and for flight-to-quality moves during market stress. In March 2020, billions moved from prime funds into government funds within days.

2. Prime Money Market Funds
Prime funds invest in a broader range of money market instruments: commercial paper, asset-backed commercial paper, negotiable certificates of deposit, time deposits, bankers' acceptances, corporate floating-rate notes and repos backed by non-government collateral, in addition to government securities.
• NAV: institutional prime funds must use a floating NAV priced to four decimals; retail prime funds (limited to natural-person beneficial owners) may maintain a stable $1.00 NAV.
• Credit risk: higher than government funds because of exposure to bank and corporate issuers; the fund adviser performs credit analysis and the portfolio is diversified to reduce single-name risk.
• Yield: generally the highest of the three categories, reflecting the credit spread over government paper.
• Liquidity fees: institutional prime funds are subject to the mandatory liquidity fee framework; all prime funds may impose discretionary fees.
• Treasury role: suited to reserve or strategic cash where the company's investment policy permits floating NAV and modest credit exposure in exchange for incremental yield. Corporations are institutional investors and therefore cannot use retail prime funds.

3. Tax-Exempt (Municipal) Money Market Funds
Tax-exempt funds invest in short-term obligations of state and local governments and their agencies: variable rate demand notes (VRDNs), tax-exempt commercial paper, tender option bonds and short-term municipal notes (TANs, RANs, BANs).
• NAV: institutional tax-exempt funds use a floating NAV; retail tax-exempt funds may use a stable NAV.
• Credit risk: depends on the issuers and on credit enhancement such as bank letters of credit or liquidity facilities supporting VRDNs.
• Yield: the lowest nominal yield because interest is exempt from federal income tax (and from state tax for single-state funds held by residents of that state). The appropriate comparison is on a tax-equivalent yield basis.
• Liquidity fees: institutional tax-exempt funds follow the same mandatory and discretionary fee rules as institutional prime funds.
• Treasury role: useful for taxable corporations and individuals in higher brackets; less useful for entities that pay little or no federal tax (non-profits, loss-making companies) because the exemption has no value to them.

Tax-Equivalent Yield Formula
Tax-Equivalent Yield = Tax-Exempt Yield ÷ (1 − Marginal Tax Rate)
Example: a tax-exempt fund yields 3.00% and the corporation's marginal federal tax rate is 21%. TEY = 3.00% ÷ (1 − 0.21) = 3.00% ÷ 0.79 = 3.80%. If a comparable prime fund yields 3.70%, the tax-exempt fund is the better after-tax choice; if the prime fund yields 3.90%, the prime fund wins. You can also work in reverse: After-Tax Yield of a taxable fund = Taxable Yield × (1 − Tax Rate).

How MMFs Work in Corporate Liquidity Management
• Cash segmentation: treasurers divide cash into operating (daily needs), reserve (known near-term obligations) and strategic (longer horizon) tiers. Government funds dominate the operating tier; prime and tax-exempt funds often appear in reserve or strategic tiers.
• Investment policy compliance: policies typically specify permitted fund types, minimum fund ratings (for example, AAAm from S&P or Aaa-mf from Moody's), maximum concentration per fund or fund family, and whether floating-NAV funds are allowed.
• Access channels: funds can be purchased directly, through bank sweep arrangements that automatically move end-of-day balances into a fund, or through online MMF portals that consolidate multiple fund families, provide holdings transparency and simplify reporting.
• Cut-off times and settlement: government funds often offer later same-day cut-offs than prime funds, an operational consideration for cash forecasting.
• Accounting classification: under U.S. GAAP, MMF shares generally qualify as cash equivalents. SEC staff guidance confirms that floating-NAV funds may still be classified as cash equivalents, though companies should document their policy.
• Counterparty diversification: MMFs spread exposure across dozens of issuers, reducing the single-bank concentration risk that arises from holding large uninsured deposits.

Risks to Remember
• Credit risk: issuer default or downgrade (prime and tax-exempt).
• Liquidity risk: heavy redemptions during stress; mitigated by liquid asset minimums and liquidity fees.
• Interest rate risk: small due to short WAM but present; a rapid rate rise can push a shadow NAV below $1.00.
• Sponsor risk: funds are not FDIC insured; sponsors have historically supported funds voluntarily but are not obligated to do so.
• Yield risk: in near-zero rate environments, expense ratios can approach or exceed gross yields, leading to fee waivers.

Regulatory Timeline to Know
• 2008: Reserve Primary Fund breaks the buck; Treasury temporary guarantee program.
• 2010: first reforms: liquidity minimums, WAM reduced to 60 days, WAL of 120 days introduced, monthly holdings disclosure.
• 2014: floating NAV for institutional prime and institutional tax-exempt funds; liquidity fees and redemption gates permitted; effective October 2016, prompting over one trillion dollars to shift from prime to government funds.
• 2020: March pandemic stress exposes weaknesses; Federal Reserve launches the Money Market Mutual Fund Liquidity Facility.
• 2023: SEC eliminates gates, raises daily and weekly liquidity minimums to 25% and 50%, adopts mandatory liquidity fees for institutional prime and tax-exempt funds, and prohibits reverse distribution mechanisms in negative-rate environments.

Exam Tips: Answering Questions on Money Market Funds: Government, Prime and Tax-Exempt

Tip 1 – Classify by holdings first. If a question describes a portfolio of Treasuries, agencies and government repos, it is a government fund. Commercial paper and bank CDs signal a prime fund. VRDNs and municipal notes signal a tax-exempt fund. Many questions hinge on this identification alone.

Tip 2 – Match NAV type to fund type and investor type. Government funds: stable NAV for everyone. Prime and tax-exempt funds: floating NAV if institutional, stable NAV if retail. Remember that a corporation is always an institutional investor, so a corporate treasurer buying a prime fund is buying a floating-NAV fund.

Tip 3 – Rank yields and risks consistently. Nominal yield from highest to lowest is usually prime, then government, then tax-exempt. Credit risk is lowest for government funds. If the question asks which fund best preserves principal or offers greatest safety during a crisis, choose government (or Treasury-only).

Tip 4 – Memorize the Rule 2a-7 numbers. 60-day WAM, 120-day WAL, 397-day maximum maturity, 25% daily liquid assets, 50% weekly liquid assets, 99.5% government securities threshold, 5% issuer diversification, 5% net redemption trigger for mandatory fees. The exam loves these thresholds, and distractor answers often use the pre-2023 figures of 10% and 30%.

Tip 5 – Always convert tax-exempt yields before comparing. Use TEY = tax-exempt yield ÷ (1 − tax rate). Check whether the question gives a federal rate only or a combined rate, and whether the investor is actually taxable; a non-profit gains nothing from a tax-exempt fund.

Tip 6 – Know what was removed and what was added in 2023. Redemption gates are gone. Mandatory liquidity fees apply only to institutional prime and institutional tax-exempt funds. Government and retail funds are not required to impose fees. An answer choice stating that a government fund must impose a liquidity fee is incorrect.

Tip 7 – Connect to investment policy and cash segmentation. When a scenario describes operating cash needed within days, favor government funds and stable NAV. When it describes reserve cash with a tolerance for floating NAV and a desire for incremental yield, prime funds are appropriate. When a policy prohibits floating NAV, institutional prime and tax-exempt funds are excluded.

Tip 8 – Remember what MMFs are not. They are not FDIC insured, they are not guaranteed by the sponsor, and they are not the same as bank money market deposit accounts (MMDAs). Questions frequently test this distinction.

Tip 9 – Watch for the accounting angle. Stable NAV relies on amortized cost; floating NAV relies on market value. MMF shares are generally cash equivalents for the corporate investor.

Tip 10 – Read for qualifiers. Words such as institutional, retail, Treasury-only, single-state and after-tax change the correct answer. Underline them mentally before evaluating the choices.

Quick Review Summary
• Government MMF: 99.5% government securities and repos, stable NAV, lowest credit risk, no required liquidity fees, federally taxable income (Treasury income often state-tax exempt).
• Prime MMF: CP, CDs, corporate and bank paper, floating NAV for institutional investors, highest yield, mandatory liquidity fee framework for institutional funds.
• Tax-Exempt MMF: municipal short-term paper, floating NAV for institutional investors, federally tax-exempt income, compare on tax-equivalent yield.
• All three: Rule 2a-7, 60-day WAM, 120-day WAL, 25% daily and 50% weekly liquidity, 397-day maximum maturity, no gates, not FDIC insured.

Master these distinctions and you will be able to answer both the definitional and the scenario-based questions the CTP exam presents on money market funds with speed and confidence.