Money Market Instruments

Each instrument answers a different question: who is borrowing (a corporation, the U.S. Treasury, or a diversified fund), and what backs the promise to repay. The sections below work through the buyer-seller mechanics, the registration thresholds, and the tax treatment the exam tests for each.

What Do Money Market Instruments Have in Common?

The money market is where short-term funds are borrowed and lent. Unlike the capital market (stocks and long-term bonds), money market instruments mature in one year or less.

• Maturity: one year or less (most under 6 months)
• Liquidity: very high; easily converted to cash
• Safety: low risk compared to other securities
• Interest: usually issued at a discount (no periodic coupon payments)
• Purpose: short-term financing and cash management

The buyer of a money market instrument is the lender of money. The seller (issuer) is the borrower.

How Does Commercial Paper Work?

Commercial paper is short-term unsecured promissory notes issued by large, creditworthy corporations to finance short-term liabilities such as payroll, inventory, and accounts receivable. It pays no periodic interest; it is sold at a discount to face value, and the investor receives face value at maturity.

Rather than draw on an expensive bank line of credit, creditworthy corporations issue commercial paper as a quick, low-cost way to bridge short-term cash needs.

• Unsecured: backed only by the issuing corporation's promise to pay, with no collateral
• Issued only by corporations with high credit ratings (investment grade)
• Rated by agencies (e.g., A-1/P-1 is the highest short-term rating from S&P/Moody's)
• Not FDIC-insured, since it is a security, not a bank deposit
• Typically held to maturity, with a limited secondary market
• If maturity exceeds 270 days, the issuer must register with the SEC

Exam Tip: Gotchas

• The 270-day maturity is necessary but not sufficient for the federal exemption. The short-term-paper exemption has two conditions: the note must arise out of, or fund, a current transaction (working capital), and it must mature within 270 days. Paper issued to finance a factory or other fixed asset is not exempt even at 30 days.
• Commercial paper is unsecured; there is no collateral backing it.
• Buying commercial paper = lending money. The holder is the lender, the issuer is the borrower.

When Is Commercial Paper an Exempt Security Under State Law?

Under the Uniform Securities Act, this type of promissory note, draft, bill of exchange, or bankers' acceptance is an exempt security at the state level only if it meets all three conditions:

• Payable within 9 months (270 days or less) of issuance
• Issued in denominations of at least $50,000
• Rated in one of the 3 highest rating categories by a nationally recognized statistical rating organization

Exam Tip: Gotchas

The 9-month maturity is only one of three conditions for state exempt-security status. A note that matures within 9 months but is issued in denominations under $50,000, or is unrated or rated below the top 3 categories, does not qualify as an exempt security at the state level. Also remember the $50,000 denomination in this test is a legal minimum for state exemption, distinct from the typical $100,000 minimum most commercial paper is actually sold in.

How Do Treasury Bills (T-Bills) Work?

Treasury bills are short-term discount securities issued by the U.S. Treasury. They are backed by the full faith and credit of the U.S. government and considered risk-free. T-bills are sold at a discount to par (face value), the investor receives par at maturity, and there are no coupon payments (a zero-coupon structure, where the return is the discount).

Maturities and auction schedule:

Key characteristics:

How Does the Auction Process Work?

• Competitive bids: the bidder specifies the discount rate they will accept (institutional investors); the bid may not be filled
• Non-competitive bids: the bidder accepts whatever rate the auction determines (retail investors); the bid is guaranteed to be filled
• Maximum non-competitive bid: $10 million per auction

How Are T-Bills Taxed?

• The discount earned is treated as interest income, not a capital gain
• Subject to federal income tax in the year of maturity or sale
• Exempt from state and local income taxes, a feature shared by all Treasury securities

Exam Tip: Gotchas

• T-bills are quoted on a bank discount yield basis (a 360-day year, with par value as the denominator), which understates the true yield. The bond equivalent yield (a 365-day year, with purchase price as the denominator) gives a more accurate comparison to other investments.
• Interest is exempt from state and local taxes (like all Treasury securities).

How Do Money Market Mutual Funds Work?

Money market mutual funds are open-end investment companies regulated under the Investment Company Act of 1940. The SEC's money-market-fund quality and maturity rule governs their permissible investments and portfolio quality and maturity. These funds invest in a portfolio of money market instruments, including T-bills, commercial paper, repos, CDs, and bankers' acceptances.

What Is "Breaking the Buck"?

Breaking the buck occurs when a fund's NAV falls below $1.00 per share. It is extremely rare, but it demonstrates that money market funds are not guaranteed.

SIPC does not fix this. The Securities Investor Protection Corporation (SIPC) protects brokerage customers against a broker-dealer's failure to return their securities and cash, up to $500,000 (including $250,000 in cash). It does not insure a money market fund against investment losses or guarantee its $1.00 NAV.

Exam Tip: Gotchas

• Money market mutual funds seek to maintain a $1.00 NAV but it is NOT guaranteed. They are NOT FDIC-insured.
• The exam tests whether candidates confuse money market deposit accounts (FDIC-insured, at banks) with money market mutual funds (not insured, securities).

How Do the Cash Equivalents Compare?

What Should You Check on Exam Day?

• Can you name the 270-day federal registration exemption for commercial paper, and do you also remember it requires the proceeds to fund a current transaction, not a fixed asset?
• Can you separately state the three-part Uniform Securities Act test for commercial paper as a state exempt security: 9 months or less, at least $50,000 denomination, and top-3 rating category?
• Do you know that T-bills are quoted on bank discount yield, and that bond equivalent yield is the more accurate comparison?
• Can you explain why Treasury interest is exempt from state and local tax but still subject to federal tax?
• Do you know why a money market fund's $1.00 NAV is a target, not a guarantee, and that these funds are never FDIC-insured?
• Can you tell competitive bids (institutional, may not fill) from non-competitive bids (retail, guaranteed fill up to $10 million) at a T-bill auction?